The riskometer

Indian mutual fund documents carry a dial with six settings. It exists because for years a saver could be sold a credit risk fund and an overnight fund with the same reassuring language.

What is required

SEBI calls it product labelling, and its stated purpose is "to help investors have an easy understanding of the kind of product/scheme they are investing in and its suitability to them."

Every scheme must be labelled on three parameters:

• the nature of the scheme — to create wealth or provide regular income, over an indicative short, medium or long term horizon;
• a one-line statement of the investment objective, followed by the kind of product (equity or debt);
• the risk, shown through "pictorial meter named 'Riskometer'".

The riskometer has six levels:

Level
Low Risk
Low to Moderate Risk
Moderate Risk
Moderately High Risk
High Risk
Very High Risk

And it has to be where you will see it: on the front page of the initial offering application form, in the Key Information Memorandum, in the scheme information document, in the common application form, and in scheme advertisements.

That last one matters. The advertisement that made the fund look attractive is obliged to carry the same dial as the document nobody reads.

What it is good at

Three things, and they are not nothing.

It makes two schemes comparable in one glance. Before it, comparing the riskiness of a short duration fund and a credit risk fund meant reading two documents properly.

It moves. The level is reviewed against the actual portfolio, so a scheme that drifts into riskier holdings has to say so. A label that changes is information — a fund whose riskometer has climbed is doing something different from what it was doing.

It is hard to argue with in a sales conversation. "Very High Risk" printed on the form is a fact that survives an enthusiastic pitch.

What it cannot do

Here is the limitation, and it is structural rather than a flaw in the design.

It describes the scheme, not your situation. The riskometer measures characteristics of the portfolio. Whether that risk is appropriate depends on your horizon, your other money, your income and what the money is for — none of which the fund knows.

A Very High Risk equity fund is entirely appropriate for money you will not touch for fifteen years, and completely wrong for a deposit on a flat you are buying next year. Same dial, opposite answers, and the difference is a fact about you.

Two schemes at the same level are not equally risky in the same way. A high-risk equity fund can fall a long way and recover; a debt fund taking credit risk can suffer a permanent loss if an issuer defaults. Both may sit at the same level. The shape of the risk is different, and only the portfolio of chapter 7 tells you which you are holding.

It says nothing about price. A large cap fund is a large cap fund whether the market is cheap or expensive. The riskometer will not move because everything got dearer, and expensive markets are exactly when the risk of a poor decade is highest.

It is not a forecast. No level implies a probability of loss, or a size of loss.

How to use it

Three habits.

Read it against the horizon, not the scheme. Decide when you need the money first. That determines what level is acceptable, and then you choose a scheme inside it. Doing it the other way round is how people end up holding equities they have to sell in a bad quarter — which chapter 9 of the equity subject shows is what turns a fall into a loss.

Notice when it changes. A scheme whose label has moved up has changed what it holds. Nothing obliges anyone to tell you why; the portfolio will.

Treat "Low" honestly. Low risk is not no risk. A low risk debt scheme can still lose money, and it has its own certainty: it will not keep pace with inflation over a long period. Chapter 7 of Finance 101 is that arithmetic.

The point

Product labelling requires a six-level riskometer on every scheme document and advertisement, reviewed against the actual portfolio. It measures the scheme's risk, not yours — so it answers a question about the fund, and the question that decides your outcome is when you will need the money.