Labelling may not affect risk perception

Investors perceive debt funds to be a safe and tax-friendly alternative to banks FDs. Grading a fund as 'very high risk' may not have a major impact

My cousin’s family had come home for dinner and their 12-year-old was watching TV and loudly mouthing the advertisements as they came on. When the “Mutual fund Sahi Hai” ad came on, right on cue he shouted: “Mutual Funds (MFs) are subject to market risks. Read offer documents carefully before investing.” 

I remembered this pre-Covid incident when I was reading about the reported move by the Securities and Exchange Board of India (Sebi) to expand the mutual fund risk-o-meter to include a ‘very high risk’ category to cover certain kinds of equity and debt schemes. My nephew jokes that the only thing people remember about mutual funds is that they are subject to market risks. In short, Sebi’s move to compulsorily include the line on market risks has had the desired impact. There are no major complaints of mis-selling of equity funds where the client was told that his principal was safe. 

However, this knowledge about the risks of investing in mutual funds comes up against the widely held perception that mutual funds mean equity funds. Whenever I have been questioned about the risks or rewards of mutual funds, the person has clearly meant equity funds. When the Franklin debt fund crisis broke, I remember a viewer asking: “While the specific debt schemes are being wound up, are the mutual fund schemes of Franklin at risk?” as if those debt schemes were not ‘mutual fund’ schemes. 

Even for equity schemes it is debateable whether the gradation of the risk between, say, ‘moderate’, ‘moderately high’, and ‘high’ makes any impression. Most fund houses routinely label equity- savings schemes as, “Investors understand that their principal will be at moderately high risk”. The same label is used for balanced and even for equity funds. The risk to the investor’s principal is vastly different in these three kinds of funds. There seems to be an attempt to play safe and publish a higher degree of risk than is warranted for an equity savings fund. Gradation of risk in a higher category seems to make no difference to the investor’s appetite for investment.  

With debt funds, the perception is that they are a ‘safe’ and tax-friendly alternative to bank fixed deposits (FDs). The only perceived difference is that the return cannot be guaranteed. The risks in a debt fund are not fully understood. Some time back a friend, who had invested in a long-term gilt fund and suffered loss in capital when interest rates rose sharply, asked: “I invested in a government securities fund and yet I have lost part of my principal. How can that be?” I had to explain the concept of interest-rate risk or how the value of your debt security declines when rates rise. So, risk in a debt fund is not limited to defaults by the issuer but can come from multifarious sources, including lack of liquidity in a paper rated below AAA. I am not sure grading some debt funds as ‘very high’ risk will by itself have a major impact. 

Setting up a differential and graded entry to investing in ‘high risk’ funds would draw attention to higher risk. Investments should only be allowed through registered investment advisers or mutual fund distributors who by regulation are required to do risk profiling and ensure suitability. Only investment above a certain limit (say, Rs 5 lakh) can be allowed directly as these high-value investors will presumably do their homework. The differential entry will signal to investors there is something different about these schemes and make the labelling effective.

The writer heads Fee Only Investment Advisers LLP , a Sebi-registered investment adviser