What Are the Risks of Investing in Mutual Funds

Be a wise investor by understanding various risks associated with mutual fund investments.
Risks of investing in Mutual Funds
4 mins
31 January 2024

It is well-known that mutual funds are subject to various types of risks that can affect their performance and returns. Mutual funds can be broadly classified into equity mutual funds and debt mutual funds, depending on the asset class they invest in. Each type of mutual fund has its own set of risks, as explained in the article below.

What makes mutual funds risky?

The inherent risk in mutual fund investments stems from their allocation across various investment instruments such as debt, equity, and corporate bonds. Given that the prices of these instruments fluctuate due to various factors, investors may experience losses.

This risk often manifests through a decline in the NAV of these investments. Nonetheless, mutual fund investors can optimise the risk-reward balance of this investment tool by recognizing the associated risks in mutual funds beforehand.

Types of risk in mutual funds

1. Risks involved with equity mutual funds

  • Volatility risk: This is the risk of fluctuations in the value of the mutual fund due to changes in the market conditions. Equity mutual funds invest in stocks, which are affected by factors such as economic cycles, corporate earnings, political events, etc. These factors can cause the stock prices to rise or fall, which in turn affects the net asset value (NAV) of the mutual fund.
  • Liquidity risk: This is the risk of not being able to sell or redeem the mutual fund units at the desired time or price. Equity mutual funds, especially those that have a lock-in period such as ELSS, are subject to liquidity risk. Sometimes, there may not be enough buyers or sellers in the secondary market, or the fund house may impose exit loads or restrictions on redemptions.

2. Risks involved with debt mutual funds

  • Interest rate risk: This is the risk of changes in the value of the mutual fund due to changes in the interest rates. Debt mutual funds invest in fixed-income securities such as bonds, debentures, government securities, etc. These securities have a fixed coupon rate and maturity date. When the interest rates in the market change, the prices of these securities also change inversely. For example, when the interest rates increase, the prices of bonds decrease, and vice versa.
  • Credit risk: This is the risk of default or delay in payment of interest or principal by the issuer of the security. Debt mutual funds are exposed to credit risk when they invest in low-rated or unrated securities that have a higher chance of default. Credit risk can result in loss of capital or income for the mutual fund investors.
  • Inflation risk: This is the risk of erosion in the purchasing power of the money due to inflation. Debt mutual funds offer fixed returns that may not be able to beat the inflation rate over time. This can reduce the real value of the investment and affect the long-term goals of the investors.
  • Concentration risk: This is the risk of overexposure to a particular security, sector, or issuer. Debt mutual funds that invest in a limited number of securities or focus on a specific theme or sector are subject to concentration risk. This can increase the volatility and vulnerability of the mutual fund to adverse events affecting that security, sector, or issuer.
  • Currency risk: This may apply to equity mutual funds also which invest in overseas securities. This is the risk of changes in the value of the mutual fund due to changes in the exchange rates. Debt mutual funds that invest in foreign currency-denominated securities are exposed to currency risk. The appreciation or depreciation of the domestic currency against the foreign currency can affect the returns of the mutual fund.
  • Rebalancing risk: This is the risk of deviation from the original asset allocation of the mutual fund due to market movements. Debt mutual funds that follow a dynamic asset allocation strategy are subject to rebalancing risk. The fund manager may change the proportion of debt and equity in the portfolio based on the market conditions. This can alter the risk-return profile of the mutual fund and affect the investors’ expectations.

Tips to combat risks associated with mutual funds

While it is not possible to eliminate the risks in mutual funds completely, here are some ways to mitigate them and enhance the returns:

  • Build a portfolio that matches your risk appetite: Before investing in mutual funds, you should assess your risk tolerance and investment horizon. Based on that, you should choose the mutual funds that suit your risk profile and goals. For example, if you are a conservative investor with a short-term horizon, you should opt for low-risk debt mutual funds. If you are an aggressive investor with a long-term horizon, you should opt for high-risk equity mutual funds.
  • Invest through systematic investment plan (SIP): SIP is a method of investing a fixed amount at regular intervals in a mutual fund. SIP helps you to reduce the volatility risk and average out the cost of purchase. SIP also helps you to benefit from the power of compounding and achieve your long-term goals.
  • Invest through systematic transfer plan (STP): STP is a method of transferring a fixed amount from one mutual fund to another at regular intervals. STP helps you to rebalance your portfolio and switch from one asset class to another based on the market conditions. STP may help you to book profits and reduce the concentration risk.
  • Diversify your portfolio: Diversification is a strategy of spreading your investments across various mutual funds with different asset classes, sectors, themes, and geographies. Diversification helps you to reduce the impact of poor performance of one mutual fund on your overall portfolio. Diversification also helps you to capture the opportunities in different segments of the market.

Risks in mutual funds and suitable solutions

Objective

Capital Protection

Liquidity

Volatility risk

Invest in low-volatility funds or index funds

Invest in liquid funds or ultra-short duration funds

Liquidity risk

Invest in open-ended funds or funds without exit loads

Invest in funds with high liquidity or low redemption time

Interest rate risk

Invest in short-duration funds or floating rate funds

Invest in funds with low interest rate sensitivity or low duration

Credit risk

Invest in high credit-rated funds or gilt funds

Invest in funds with low credit risk or high-quality securities

Inflation risk

Invest in inflation-indexed funds or dynamic bond funds

Invest in funds with high real returns or inflation-adjusted returns

Concentration risk

Invest in diversified funds or multi-cap funds

Invest in funds with low exposure to a particular security, sector, or issuer

Currency risk

Invest in domestic currency-denominated funds or hedged funds

Invest in funds with low exposure to foreign currency-denominated securities

Rebalancing risk

Invest in balanced funds or hybrid funds

Invest in funds with a fixed asset allocation or low turnover ratio


Conclusion

By understanding the risks and following the tips mentioned above, you may combat the risks and aim to enhance your returns. You should also monitor your portfolio regularly and make changes as per your risk appetite and goals.

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Frequently asked questions

Are all mutual funds risky?

Yes, all mutual funds carry some risk. Some mutual funds like debt funds are less risky than others like equity funds.

Are mutual funds safe?

Mutual funds are regulated by the governing boards of SEBI and AMFI, and RBI regulates Money Market and Liquid schemes, which ensure transparency and security of investors’ money. However, mutual funds are subject to market risk and do not guarantee fixed returns.

Do mutual funds outperform the stock market?

Some funds may outperform the stock market over a long-term horizon. This depends largely on the fund manager’s skill and the market conditions. However, past success does not prove that future results will be the same.

Should I move my stocks to a mutual fund?

The choice depends on your risk appetite and portfolio make-up. Mutual funds offer professional management, diversification, and convenience, but also charge fees and expenses. Stocks offer direct ownership, higher returns, and lower costs, but also involve higher risk and volatility. To get the best of both worlds, you can split your funds between them.

What is market risk in mutual fund?

Market risk in mutual funds refers to the potential for losses due to fluctuations in the overall market conditions, impacting the value of the fund's investments.

How many types of risk are there in mutual funds?

There are various types of risks in mutual funds, including market risk, credit risk, liquidity risk, interest rate risk, and inflation risk.

What is liquidity risk in mutual fund?

Liquidity risk in mutual funds indicates the possibility that certain investments held by the fund may not be easily sold or converted into cash without a significant loss in value, affecting the fund's liquidity.

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