Often, people invest in mutual funds without understanding the nature of funds. The sole criterion used to select a fund is return expectation but while doing so they tend to ignore the level of risk they are exposed to. Such bad decisions result in loss on investment. To simplify the process of gauging the risk involved in an investment proposition, Securities and Exchange Board of India (SEBI) introduced colour codes this March. It was decided that product labels carrying details of the scheme be disclosed on the front page of initial offering application forms and they be also placed in common application forms and advertisements. Under colour code system that is currently in practice, funds carrying high risk to the principal are indicated in brown; those carrying medium risk are indicated in yellow. Blue colour denotes lowest risk to principal.

Within few months from the introduction of colour code system, SEBI recently asked Association of Mutual Funds in India (AMFI), to make some modifications. SEBI has directed AMFI to make the colour labels uniform. At present, two mutual fund schemes from different fund houses falling under the same category may be assigned different colours at the discretion of the fund house. This may confuse investors and therefore SEBI has directed AMFI to implement uniform colour code system.

PersonalFN is of the view that, the changes suggested by SEBI are welcome and may make the current system of colour coding slightly better. But even with modifications, the real effectiveness of colour codes would be extremely limited and may be used just as one of the very basic indicators for identifying risk profile. For example, labeling all equity oriented funds as ‘risky’ doesn’t account for difference in risk levels of a largecap fund and a mid & smallcap fund. Similarly it may denote no difference in the risk level of a sectorial fund and a diversified equity fund. PersonalFN believes that AMFI would have to take into account such factors. Furthermore, change in fund management style also affects the risk profile. In debt funds too, treating all short term debt fund at par on risk would be inappropriate if there is any difference in the asset quality. Moreover, it is still unclear as to how the AMFI would standardise schemes to be labeled with same colours. Unless AMFI gives clarity on this, effectiveness of colour codes may remain limited. More comprehensive the process of standardisation better it would be for making colour labels a good indicator.

Lastly, PersonalFN is of the view that before you assess the risk profile of a mutual fund, it is imperative to check your risk appetite and risk tolerance. Factors such as your Income, Expenses, Financial Responsibilities and Nearness to goals decide your risk tolerance while risk appetite is your inclination to take risk in order to benefit from investments. PersonalFN believes that with help of sound financial planning which also considers suitable asset allocation, you may optimise returns on your investments without disregarding the element of risk. As remains the question of assessing risk involved in a particular mutual fund, you may be better off going beyond colours.

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