Risks Associated with Mutual Funds and How to Deal with Them
When it comes to any investment, returns and risks go hand in hand. The more the expected returns of an investment, the more the risk of losses will be. This makes it crucial for an investor to carefully weigh a mutual fund’s risks against the potential rewards.
If you are well aware of the risks associated with mutual funds, you can make better investment decisions. It will also help you formulate effective strategies to combat the risks. The following sections will explain the various risks involved with mutual fund investments.
Why do Mutual Fund Investments involve Risk?
Risks in mutual funds involve the chances of loss of capital or reduction of returns. The level of risks that a mutual fund carries depends on the asset class it invests in, like equity, debt or other securities. The equity asset class carries the highest risk, while money invested in government bonds tends to carry the lowest risk.
The values of these underlying assets fluctuate depending on the movements of the market. Investors in risky assets stay invested for a long time to get higher returns. Another widely-used strategy is to diversify one’s investments so that the risk of one asset class is mitigated by another.
Please note that a fund’s NAV (Net Asset Value) depends on the values of the securities held by the fund’s portfolio. So, if the value of the underlying instruments takes a downturn, the fund’s NAV also falls.
What Are the Standard Risk Factors?
Here are some of the common risk factors that investors need to be aware of:
- Investors need to remember that all mutual funds are subject to market risk, and no fund can offer guaranteed returns.
- If the underlying assets’ interest rates/values/prices fluctuate, the investment value might increase or decrease accordingly.
- Investors should note that mutual funds are associated with many investment risks, such as settlement, default, liquidity, and trading volumes. In addition, there remains the possibility of losing the invested amount.
- The NAV is also influenced by many other factors that affect the money and capital markets, such as currency exchange rates, changes in interest rates, taxation, changes in government policies, political and economic factors, etc.
- Moreover, if the stock and bond market faces increasing volatility, it will affect the fund’s NAV.
- An important factor that people must understand is that a good performance of a mutual fund in the past does not guarantee its repetition in the future.
What Are Specific Risk Factors?
Now, let us look at some specific risks in mutual funds:
Risks of investing in Equity Funds
The following are the risks associated with equity and equity-oriented funds:
- Price risk
Financial experts consider equity and equity-linked instruments to be quite volatile and subject to daily fluctuation of prices. Poor market performance can lead to sudden changes in prices, causing losses for investors. Such mutual fund risks are called systematic risks as they cannot be controlled.
- Risk of losing principal
Investors should note that equity and equity-related instruments carry risks of considerable losses. There always remains the possibility of a loss of the principal amount. So, if investors are not ready to bear this loss, it will be a good idea to stay away from equity investments.
Similarly, in case of Debt funds, the investors could lose their principal amount due to any credit or interest rate risk.
- Event risk
Equity funds are also subject to sector or company-specific price risks, called event risks. Such events can include macroeconomic factors such as new regulations, government directives, unfavourable economic conditions, etc. Investors need to be ready to face the possibility of this risk when they choose to invest in equity funds.
Risks of Investing in Debt Funds
Following are the various risks associated with debt mutual funds:
- Interest rate risk
Interest rate movements share an inversely proportional relationship with the market value of fixed-income securities. Thus, when the interest rates increase, the price of debt securities in a mutual fund’s portfolio decreases, and as a result, its value decreases. The extent of the rise and fall greatly depends upon the underlying assets’ coupon rate, maturity date and yield. Interest rate risk is generally high for the Debt funds investing in securities with longer duration.
- Credit risk
Credit risk is the possibility that the issuer of fixed-income security fails to pay the stipulated interest or principal amount. If there is a default, the debt fund’s NAV will fall as it does not receive the interest payout or loses the capital invested. However, even if there is no default, the prices of securities may change if the issuer’s credit rating drops.
Investors need to be very careful about this risk as it can result in losses in the initial investment. Government securities have negligible credit risk as they come with a sovereign guarantee. Corporate bonds carry some credit risks, which depend on their safety levels. Bonds with higher credit ratings tend to be much safer.
- Counterparty risk
Every transaction has counterparties without whom the economic transaction would not take place. For example, the buyer of an asset is set against the seller who wishes to sell off the asset. The probability of an absence of counterparties is called counterparty risk.
The risk of a counterparty failing to fulfil its financial obligations is another counterparty risk. If a counterparty defaults, the debt fund will also face losses.
- Spread risk
The difference in the yield of two bonds with similar maturity but different credit quality is referred to as credit spread. Investors should note that the credit spreads on corporate bonds might alter with different market conditions.
For example, if the credit spread widens, the market value of the debt securities may fall. The same can happen for floating rate securities. Their value might depreciate if the credit spread over the underlying benchmark widens.
- Reinvestment risk
People should be aware that investments in fixed-income securities are associated with reinvestment risk. Reinvestment risk is the chance that cash flows received from an investment will earn less when put to use in a new investment.
In addition, please note that any investment that generates cash flow is subject to this risk.
- Prepayment risk
Prepayment risks occur when a borrower pays off his loan before the stipulated date. Generally, people have a tendency to pay off high-interest loans when interest rates fall. As a consequence, the average maturity of ABS (Asset Backed Securities) reduces.
However, the prepayment risk of a mutual fund can also come from the rise in interest rates. For example, a borrower may pay off their mortgage after the sale of their house. Another example would be when a borrower pays off their car loan after the sale of his car.
What Are Some Other Crucial Risk Factors?
Given below are important details of risk factors that you need to know:
- Liquidity risk
This risk factor is applicable for both equity and debt schemes. Equity funds might have rigid rules regarding lock-in periods. Once people invest in these funds for a long investment horizon, they might find it difficult to withdraw the funds without facing a loss.
On the other hand, established institutions such as companies, banks, governments and mutual funds engage in the daily trading of debt securities. There may be certain securities that have less liquidity than others. Moreover, a volatile political and economic environment can lead to a decrease in the liquidity of debt securities.
Some mutual funds might not be able to sell off the securities and repay investors in both of these cases. Financial experts have observed that reduction in liquidity is mainly a result of an unfavourable economic environment. We have observed the same scenario happened in some of the debt schemes of Frankiln Templaton.
- Concentration risk
This is another risk that can affect both equity and debt funds. Equity funds become subject to concentration risks when an individual invests in numerous funds having the same investment strategy. For example, the portfolio of a large-cap fund of an AMC (Asset Management Company) may overlap with its multi-cap fund and aggressive hybrid fund.
In addition, concentrated exposure to a particular sector or theme also leads to concentration risks. An investor putting all of their money in a particular fund or sector is another example of concentration risk.
When it comes to debt funds if a person invests in a debt scheme of a single fund house, there lies a possibility of concentration risk. This is mainly because every fund house interprets the movements of the market and interest rate in its own way.
These subjective interpretations influence the selection of the debt instruments that the fund invests in. In addition, if long-dated securities are concentrated in a debt fund, the latter might underperform if interest rates rise. This is because long-dated securities are vulnerable and may fall during interest rate movements.
- Currency risk
Foreign exchange rate risk or forex risk are some other phrases people use to define currency risk. It is a result of the differences in the prices of currencies. Investors and businesses operating worldwide may face currency risk, which mostly results in irregular and non-uniform profits and losses. Moreover, people who invest in international mutual funds may also face currency risk.
Some Important Tips for Mitigating Risks
Detailed below are the strategies to mitigate risks from a mutual fund investment:
- In order to reduce the credit risk of your portfolio, you should choose a fund that invests in high-rated securities with a historical record of generating good returns well in time.
- If you wish to mitigate liquidity risk, focus on diversifying your investment portfolio with funds investing in assets having moderate to high liquidity
- Invest your money in various sectors and asset classes to mitigate the concentration risk.
- People can effectively tackle market volatility by diversifying their portfolios in low to moderate-risk funds.
- An effective strategy to deal with inflation and build wealth is putting money into equity funds and other schemes that can generate higher risk-adjusted returns.
What Are the Ways to Combat the Risks of Mutual Fund Investment?
Given below are effective ways to combat the risks involved in mutual funds:
- Evaluate your risk appetite
Assessing one’s risk appetite is a crucial step before investing in a mutual fund. Risk appetite refers to an individual’s risk-taking ability with the capital he wishes to invest. This evaluation helps align one’s investment portfolio with risk-taking capability, resulting in better investment decisions.
- Diversify your portfolio
Portfolio diversification or allocating one’s money in a combination of assets is an effective strategy to combat risk. This is because the profits earned from one investment can offset the loss incurred in another.
- Invest through SIPs
This investment route distributes the risk burden effectively. If an individual opts to invest through a Systematic Investment Plan (SIP), they will benefit from rupee cost averaging and compounding. The investor receives units of the fund equal in value to the fixed amount that they invest depending on its current NAV (Net Asset Value).
- Select STP for lumpsum investment
A Systematic Transfer of Plan (STP) takes place when an investor transfers funds from one scheme to another. By shifting your mutual fund investment to a low-risk mutual fund, you can reduce the risks in unfavourable market conditions. Moreover, it distributes the risks across a period and reduces the average investment cost.
People need to be aware of the risks of mutual funds before they invest. Though every investment carries risks, investors can effectively mitigate them by evaluating their risk profile, diversifying their portfolio and ensuring that schemes do not overlap. It is always important to check the downsides of a particular investment before putting money into it.
FAQs about Risks Associated with Mutual Funds
How do I analyse risks in mutual funds?
You can check a mutual fund’s risk by evaluating its risk metrics such as beta, alpha, standard deviation and Sharpe ratio.
What is a Sharpe ratio?
A fund’s Sharpe ratio denotes its potential risk-adjusted returns. A high Sharpe ratio is indicative of higher risk-adjusted returns. The Sharpe ratio compares the return of an investment with its risk.
What factors can help me determine my risk appetite?
Crucial factors that help you determine your risk appetite are age, financial objectives, current and expected income, insurance cover and net worth.