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The regulator’s new rule to create colour codes for mutual funds schemes would achieve nothing simply because investment outcome is binary (profit or loss) and making profit depends significantly on the method of investment, including timing and somewhat on selection. It has nothing to do with high or low risk attached to a product category
The Securities and Exchange Board of India (SEBI) recently released a circular to mutual fund houses to implement the concept of product labelling starting from 1 July 2013. The Association of Mutual Funds of India (AMFI) had put forward this suggestion to the market regulator last month. In line with the suggestion, SEBI has asked fund houses to label their products depending on the risk associated with the product. The product labelling will have colour codes. The three colour codes would be ‘brown’ which signifies high risk, ‘yellow’ signifies medium risk and ‘blue’ signifies low risk.
The move has been done to “avoid mis-selling and to provide investors an easy understanding of the kind of product/scheme they are investing in and its suitability to them”, mentions the circular. However, categorising products merely based on the risk associated with an asset class is not of much value. Many people would already be aware of the risk associated with equities; hence this form of product labelling would not be that helpful.
The labelling will be carried on the application forms, key information memorandum (KIM), scheme information documents (SIDs) and all advertisements. SEBI has done this to root out mis-selling. But another issue is that how many investors actually read these documents, given that SEBI’s borrowing from the West has made them unreadable. Then comes the issue of investors wanting to sign off their money based on whom they trust.
The regulator is in fact treating financial products as durables or other consumer products, a mistake what most savers make. You may not buy a consumer product that is not energy efficient, but does that mean you should not buy an investment if it puts your money in a high risk asset class? In fact, investing in a product based on its risk alone is not sufficient; financial products are much more complex. Who would explain this to lay investors and why?
The main issue is identifying the risk associated with a product. As per the product labelling, all equity schemes will carry the high-risk tag, hybrid schemes will have the medium risk tag and fixed income schemes will have the low risk tag. This is a very basic level of classification. In fact, many savers do not invest in equities for the same reason of high-risk associated with the investment. It may prevent mis-selling to some extent if an advisor is trying to pass on a high-risk investment as a low risk (assuming the investor diligently reads the application form). Apart from that, the product labelling does not help the investor much.
In the same product category itself, there could be a huge difference in the return of the schemes. For example, over the last one year, the best equity scheme delivered a return of over 15%, but the worst scheme of the same category delivered a return as low as -14%. What about small-and mid-cap schemes which have a greater risk associated with them? Would amateur investors be able to distinguish the risk associated with these products?
Also, hybrid schemes which would fall under the medium risk category have been poor performers. There are schemes in this category that keep an allocation towards gold as well. It is not clear from the circular how would such schemes which invest in gold be classified.
Finally, investment success is significantly based on when you buy and when you sell. The problem of the first is taken care of somewhat by rupee cost averaging which is one of the best-known ways of dealing with risk.