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For most investors, choosing the right mutual fund can be confusing, given the various categories and obscure nomenclature. If you don't have an adviser to guide you, it can be a tough exercise.
To simplify the process, the Securities and Exchange Board of India ( Sebi) has put in place a colour coding system, along with a product labelling mechanism, which will have to be adhered to by fund houses from 1 July. Will the new system make life easier for the investor? Here's how to interpret the mechanism and make the right buying decisions.
How it works
Both the existing and new schemes will have to display the colour coding on the application form, as well as the offer document, next to the name of the scheme. All their advertisements will also carry this coding. The schemes will be classified into three colours, each denoting a different level of risk. Blue will signify the lowest risk and the category will include debt funds, such as income, gilt, dynamic bond funds, as well as fixed maturity plans.
This category is meant for anyone who is looking to invest safely and is not comfortable with volatility and uncertainty in returns. Yellow will stand for schemes that bear a moderate level of risk. This includes all hybrid products, such as monthly income plans (MIPs), balanced funds, as well as multi-asset funds, which invest in both equity and debt, even gold.
This category is for those who seek high returns without taking on much risk. The brown colour will imply that the fund carries a high degree of risk, and will include all diversified equity, index and sectoral funds. The colour is meant to serve as a caution to riskaverse investors, while indicating the potential for earning higher returns.
The scheme documents will also carry a 'label', or a basic description of the scheme, alongside the colour coding. This will be a short text outlining the scheme objective (to create wealth or provide regular income), its nature, as well as the instruments it will invest in (equity or debt). Mutual funds will also carry a disclaimer: 'Investors should consult their financial advisers if they are not clear about the suitability of the product.'
Watch out for
This system is designed to help investors choose funds that are suited to their risk profiles. However, it will not be able to capture the risk details for each scheme. At best, it will provide a basic understanding of the risk associated with the product. The diversity and options in mutual funds are such that a simplistic colour code will not be able to fully capture the traits of all schemes.
Dhirendra Kumar, CEO, Value Research, says, "The system provides a sketchy classification and is simplistic in its design." The way the colour codes have been assigned and schemes grouped in each category means that contrasting fund types are placed in the same basket.
For instance, MIPs and balanced funds have been assigned yellow colour, which signifies medium risk. However, the two are not at the same risk level because MIPs restrict the equity exposure to 20%, while balanced funds invest up to 65% in equity. An uninformed investor is likely to treat the two at par. Says Kumar: "Balanced funds should belong to the brown category as they carry a higher risk."
Similarly, within the brown category, supposed to symbolise the highest risk, both mid- and small-cap funds and index funds find a mention. As any expert will tell you, the risk in actively managed mid- and small-cap stocks is much more than that in passive index funds. Also, while the blue colour will include the lowest risk investments in the form of debt funds, the presence of gilt funds is slightly misleading.
This is because they take on higher risk through exposure to longer maturity instruments, the values of which are more sensitive to interest rate changes than shorter tenure paper. Liquid funds or short-term debt funds, on the other hand, involve much lower risk. If you invest in a gilt fund during a rising interest rate environment, thinking it carries low risk, you could be in for an unpleasant surprise.
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