How SEBI’s New Risk Management Framework for Mutual Funds Will Help Investors

SEBI has revised the risk management framework in the wake of significant development in the mutual fund industry and in the financial markets as a whole. The developments include innovation in products, investment in newer asset classes, distribution landscape, technological evolution, investor penetration and awareness, increase in risk elements, etc.

SEBI's new risk management framework will be segregated into 'mandatory elements' that every Asset Management Company (AMC) will implement, and 'recommendatory elements' that the AMCs can consider implementing.

SEBI has outlined a comprehensive guideline for managing the key scheme-specific risks such as governance risk, investment risk, liquidity risk, credit risk, etc., as well as AMC-specific risks such as operational risks, cyber risks, reputation and conduct risks, sales and distribution risks, etc., click here to read it in detail.

SEBI has stated that the risk management framework should, inter-alia, have the following characteristics:

• It should be an integral part of the mutual fund's processes and governance framework, at both the operational and strategic level.

• It should be customised to both the AMC's and scheme's risk profile.

• It should focus on potential risks and implement mitigation and control measures.

• It should be dynamic and flexible enough to identify new risks that emerge and make allowances to those risks that no longer exist.

Mutual fund houses will perform a self-assessment of their risk management framework and submit a report to their Board along with the roadmap for the implementation of the framework. The revised framework will come into effect from January 01, 2022. However, AMCs can choose to adopt the provisions of the circular before the effective date.

Governance and organization of Risk Management Framework

SEBI in its circular has stated that risk management will be an independent and specific function of the AMC. AMCs will appoint a CXO level officer who will be responsible for the risk management of specific functions of the AMC/Mutual Fund. For instance, there should be dedicated risk officers for various key risks such as Chief Investment Officer to manage investment risk, Chief Compliance Officer to manage compliance related risk, Chief Operating Officer to manage operational risk, Chief Information Security Officer for cyber security, etc.

In addition, the AMCs will appoint a Chief Risk Officer (CRO) who would be responsible for the overall risk management of the mutual fund operation including the key risks.

However, for the overall risk management of the mutual fund, along with the management, both the board of AMC and trustees will also be responsible. For this purpose, both the AMC and the trustees should mandatorily have separate Risk Management Committees (RMCs).

These committees will undertake annual review of RMF at both AMC and scheme level. The CRO should be part of the RMCs. The RMCs will report to the Board of AMCs and trustees respectively and also recommend long term solutions regarding risk management, both at the AMC level as well as the scheme level.

SEBI circular further states that there should be clear differentiation between the roles and responsibilities of the respective CXOs and the CRO. The CRO or the risk management function of the CRO cannot be entrusted with day to day functioning, the responsibility for which will lie with the respective CXOs.

Furthermore, the AMC should maintain risk metric for each mutual fund scheme. The risk metric should incorporate each type of key risk like investment risk, liquidity risk, credit risk, etc. along with the path to maintain the targeted risk level. The metric may incorporate evaluation of risk levels vis-a-vis an appropriate benchmark, wherever applicable.

The RMCs should meet at least once in a quarter to review various risks including risk metrics at both the scheme and the AMC level and assist the board of AMCs and trustees in discharging their duties in this regard.

In a nutshell

SEBI had first introduced the risk management framework in September 2002. However, that did not deter some mutual fund houses from taking excess risk. It remains to be seen if SEBI's review of the risk management framework can discourage such mutual fund houses/schemes from taking investors' interest for granted.

Risk management is an important aspect that determines the consistency of a scheme's performance. Some quality mutual fund houses/managers have been following this more diligently than others thereby rewarding their investors. As an investor, instead of focusing only on quantitative parameters, you should preferably invest in mutual fund houses/schemes that follow prudent investment practices and have robust risk management system in place.

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Warm Regards,
Divya Grover
Research Analyst

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