13.2 Risk Levels in Mutual Fund Schemes

The Six-Level Scale

Every scheme discloses its risk level on a standardised scale:

The mapping above is indicative, not fixed, and that is precisely the point of the design.

It Is Computed from the Portfolio

The most important property, and the most examined:

The risk-o-meter reading is derived from the scheme's actual holdings, not from its category name.

For an equity portfolio the computation considers market capitalisation, volatility and liquidity of the holdings. For a debt portfolio it considers credit quality, interest-rate risk and liquidity. Other assets have their own parameters.

The consequence is that two schemes in the same category can carry different readings, and a single scheme's reading can change over time as its portfolio changes. A category label is a constraint; a risk-o-meter reading is a measurement.

Monthly Evaluation and Disclosure

Why It Is an Early-Warning Indicator

This is the practical value a distributor should extract.

A debt scheme reaching for yield by shifting into lower-rated paper will show a rising risk-o-meter reading while its returns still look attractive — indeed, its returns look better precisely because it is taking more credit risk. The deterioration in quality is visible in the risk-o-meter months before it becomes visible in performance, and years before it might become visible in a default.

The same applies to an equity scheme drifting down the capitalisation scale in search of returns.

A change in the risk-o-meter is therefore a question, not a conclusion. The right response is to look at the monthly portfolio and ask what changed: rating profile, duration, capitalisation split. The answer is always visible in the disclosures.

Using It with Investors

What it does well:

• Gives a standardised, comparable reading across every scheme and fund house
• Communicates risk visually to investors who will not read a risk factors section
• Provides a monthly signal of change
• Is mandatory, so it exists for every scheme

What it does not do, and must not be presented as doing:

• It does not quantify potential loss. "Very High" does not state how much could be lost.
• It does not assess suitability. A Very High scheme is entirely appropriate for a twenty-five-year goal and entirely inappropriate for a nine-month one. The risk-o-meter describes the scheme; suitability depends on the investor.
• It does not predict returns.
• It is not a substitute for reading the scheme-specific risk factors.

The second point is the one distributors most often get wrong. An investor who says "I want only Low or Moderate schemes" for a retirement goal 25 years away has misunderstood the indicator, and correcting that misunderstanding is the distributor's job.

Related Disclosures

• Potential Risk Class matrix for debt schemes, classifying them by maximum interest-rate risk and maximum credit risk, which gives a more precise two-dimensional picture than a single risk-o-meter level.
• Stress testing and liquidity disclosures, particularly for mid and small cap schemes, showing how long liquidation of a stated proportion of the portfolio would take.

What a Distributor Should Do

1. Show the risk-o-meter at the point of recommendation and explain what the level means.
2. Explain that it reflects the current portfolio and can change.
3. Set the expectation that changes will be communicated by the AMC.
4. When a reading changes, look at the portfolio and explain the cause rather than reacting to the symbol.
5. Never present the risk-o-meter as a suitability assessment; suitability requires the investor's goal, horizon and profile.

The Potential Risk Class Matrix in Detail

For debt schemes the risk-o-meter's single reading is supplemented by a Potential Risk Class (PRC) matrix, in force since 1 December 2021, which separates the two risks that a single reading blends together. Every debt scheme is placed in one of nine cells.

Maximum interest-rate risk, measured by the scheme's Macaulay duration (MD):

Maximum credit risk, measured by the scheme's Credit Risk Value (CRV), where a higher CRV means safer paper:

The cell is written as a letter and a numeral: A-I is the most conservative combination available, C-III the most aggressive.

How to read it. The cell states a ceiling, not a description of today's portfolio. A scheme in cell C-III is permitted to take high credit and high duration risk; it may currently be doing neither. The risk-o-meter tells you what the scheme is doing now; the PRC cell tells you what it is allowed to do. Both are needed, and they answer different questions.

Once a scheme has selected its cell, a repositioning into a cell carrying higher maximum credit risk or higher maximum duration risk than the one chosen is treated as a change in the fundamental attributes of the scheme. That triggers written communication to every unitholder and a 30-day exit window at applicable NAV without exit load. Moving to a lower-risk position needs no such process, and the original one-time placement of existing schemes into cells was likewise not a fundamental attribute change. The asymmetry is deliberate: the protection exists for the direction in which an investor can be harmed.