Mutual fund labeling: What colour is your fund?

Come July 2013, mutual funds are set to become more colourful; literally! We are talking of the new SEBI’s circular on product labeling in mutual funds.
What exactly is product labeling and what does it seek to do? To provide investors with an easy understanding of the nature of the scheme and their suitability, mutual funds would be required to label their schemes on the following parameters:
1. Nature of the scheme – to create wealth or generate income – and time horizon (short/medium/long)
2. A brief about the fund’s investment objective and whether it is an equity or debt product
3. Use of colour codes to indicate risks: blue indicates that your principal money is at low risk, yellow suggests medium risk and brown high risk.
4. A disclaimer that investors should consult their financial advisors if they are not clear about the product.
This shall be displayed in scheme application forms, KIMs, SID and advertisements.

The colour code risk
The illustration provided in the SEBI circular’s sample suggests that
– All debt funds will be categorized under the blue label (principal at low risk)
– All balanced and hyrid funds under the yellow colour (principal at medium risk)
– All equity schemes in brown colour (principal at high risk)

Now, this colour coding may not convey what it needs to and may even throw a wrong picture at times.
Consider this: liquid funds and gilt funds would be termed low risk and fall under the same category. But they aren’t the same, with the latter being significantly more risky. Debt-oritented funds (like MIPs) and equity-oriented balanced funds would both come under the same risk category (medium). But here again the latter is far riskier than the former, given higher holdings in equity.

Within equity too, a diversified fund’s risk may be far lower than a theme fund with risk of losing principal possibly higher in the latter.

While efforts to create more awareness about products is certainly welcome, over-simplifying may sometimes lead to risk of mis-communicating to investors. A more detailed risk grading system or classifying each category according to the hierarchy of risk may be a better representation than bunching them together under 3 colours.