Don't rely on colour codes for full picture

The system could be used as a starting point to understand the risks associated with mutual funds but should not be used in isolation

The Mutual Fund Advisory Committee of the Securities and Exchange Board of India met last week. Among other things, it suggested two new colour codes be introduced, in addition to the existing three. These five colours represent very low, low, medium, high and very high risks with various products. The market regulator might soon come up with detailed guidelines re-aligning different MF products with the colour code system.

The concept of colour codes was introduced in July 2013, to educate investors about the risks associated with different kinds of funds. It was meant as a quick, pictorial guide, doing away with the need for complicated jargon.

Has the system helped investors? "It has helped them broadly distinguish between equity and debt funds," said Vidya Bala, head of MF research, Fundsindia.com. "It is particularly useful for do-it-yourself first-time investors, with no idea about MF investing."

According to Surajit Mishra, executive vice-president at Bajaj Capital, retail investors have started asking more questions to distributors after introduction of this system. "They now understand that brown means risky and that they can lose their capital if they put money into equities," he said.

In the existing system, the level of risk is depicted by colour code boxes. Blue indicates low risk to the principal, yellow shows medium risk and brown depicts high risk. The product label has to be disclosed in application forms, scheme advertisements and important documents of the scheme.

Sectoral observers believe investors cannot rely on these codes alone to make a sound investment decision. "It's a good starting point for investors to understand the risk level of a product at a broader level. However, investors should dig deeper into the risks associated with a particular scheme and understand this through financial advisors," said Raghav Iyengar, head, retail and institutional business, ICICI Prudential AMC.

DECODING THE COLOUR CODE

• Very low risk*

(Liquid funds, liquid-plus funds)
How do these compare with low risk-free products like bank fixed deposits?
Are the returns similar or better?
Do I have to pay short-term capital gains tax?

• Blue: Low risk

(Short-term bond funds, income funds, gilt funds)

As these are market-linked, are they more volatile?
Should I invest in these for the short or long term?

• Yellow: Medium risk

(Balanced funds, monthly income plans)
What is the portfolio allocation to debt, equity and other instrument?
What will be the tax treatment, like equities or debt?

• Brown: High risk

(Equity diversified funds, index funds, large-cap funds, mid-cap funds)
How long should I invest in these?
What is the portfolio allocation to large-cap, mid-cap and small-cap stocks?
How tax-efficient are they?

• Very high risk*

(Sector funds, thematic funds)
What should be my exposure to these?
How different is it from a normal equity fund?

Issues
For example, he says, a balanced fund might have lower risks than a sector-focused scheme, though both are coded as brown. Similarly, most fixed income schemes can be coded as blue, even if the credit profile of the papers they invest in vary significantly. Also, the current system does not help differentiate the risks associated between schemes of different fund houses or take into account a fund manager's ability to manage a fund or a scheme's track record.

"An income fund or gilt fund is supposed to be safe. But what if the interest rate decision goes wrong? Similarly, equities are labelled brown and deemed unsafe but what if the investment horizon is for more than 10 years? The colour code does not tell you anything about it," said a fund advisor, on condition of anonymity.

Bala says it is premature to expect investors to understand all the risks associated with funds by simply looking at the colour codes. "It's only the first step to understanding the risks and does not provide sufficient information for a final decision. The investor also has to know the characteristics of the fund, its past performance and his or her own risk profile."

The other problem with the existing system is that fund houses can use their discretion to label the same products differently. For instance, an income scheme from a particular fund house could be labelled blue, implying low risk. That from another fund house could be labelled yellow, implying medium risk. The regulator had earlier wanted standardisation, fearing that different colours used against similar schemes could confuse investors. No such standardisation has been implemented.

Guide
In the coming months, investors might have two more colours to look at, one depicting very high risk and the other showing very low risk. "Three colours might be a bit of an oversimplification but adding too many colours could confuse investors. One has to strike a balance between simplicity and accuracy," said Dhirendra Kumar, chief executive, Value Research, an MF tracker. He added that investors solely guided by the colour codes could be misled into investing in schemes that they shouldn't.

Mishra believes a more prudent way to manage risk is to set a minimum investment cap for retail investors. "Instead of introducing more colours, a high minimum application limit, say Rs 3-5 lakh, should be set for the riskiest category of funds, such as sector funds. This will ensure retail investors don't invest in such funds or get swayed by the flavour of the season."