Mutual funds, like any investment, involve inherent risks. These risks can be likened to the calculated risks taken by cricket batsmen. While aiming for a big score, they may choose aggressive shots that, while potentially rewarding, also carry the risk of dismissal.
Similarly, in mutual funds, investors seek higher returns but must be aware of the associated risks. These can include market fluctuations, credit risk, liquidity risk, and more. By understanding these risks and adopting a diversified investment strategy, investors can strive to maximize returns while mitigating potential losses.
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 is the risk of a mutual fund?
Mutual funds, while offering diversification and professional management, are subject to various risks that can impact their performance. Market risk, arising from fluctuations in underlying securities, is a primary concern. Interest rate risk, particularly for debt funds, stems from potential changes in interest rates that can affect bond prices. Credit risk emerges when issuers of securities within the fund default on their obligations.
Furthermore, liquidity risk, the difficulty of selling or redeeming fund units, can arise in volatile market conditions. Management risk is also a factor, as the fund's performance is influenced by the decisions of its manager. Investors should carefully consider these risks when evaluating mutual fund investments, aligning their choices with their financial objectives and risk tolerance.
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 recognising the associated risks in mutual funds beforehand.
General risks of investing in mutual funds
Investing in mutual funds, while offering potential benefits like diversification and professional management, also involves various risk factors. Prospective investors should carefully consider these risks before making any investment decisions:
1. Market risk
- General market risk: The overall performance of the market can significantly impact mutual fund returns. Factors such as economic conditions, government policies, interest rates, and investor sentiment can influence market fluctuations.
- Security-specific risk: Individual securities within the fund may face risks specific to their issuer or industry. For instance, a company may default on its debt or experience a downgrade in its credit rating.
2. Liquidity risk
- Trading volume: The ease with which a mutual fund's shares can be bought or sold depends on the volume traded in the market. Low liquidity can hinder the ability to exit the investment at a desired price.
3. Inflation risk
- Purchasing power: Inflation can erode the purchasing power of your investment over time, reducing the real return.
4. Loan financing risk
- Leverage: Borrowing to invest can amplify both gains and losses.
- Collateral requirements: If the investment's value falls, investors may be required to provide additional collateral or reduce their loan balance.
- Interest rate fluctuations: Changes in interest rates can affect the cost of borrowing and impact overall returns.
5. Manager's risk
- Investment expertise: The performance of a mutual fund is closely tied to the skills and decisions of its manager. A lack of experience or expertise can negatively impact the fund's returns.
6. Non-compliance risk
- Regulatory adherence: Failure to comply with laws, regulations, or internal policies can pose risks to both the mutual fund and investors' interests.
It is essential for investors to thoroughly understand these risks and assess their own risk tolerance before making investment decisions. Consulting with a financial advisor can provide personalized guidance and help mitigate potential risk.
Types of risk in mutual funds
Before investing in mutual funds, it is essential to understand the various risks involved. These risks can be broadly categorised into risks involved with equity mutual funds and risks involved with debt 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
Investing in mutual funds involves various risks. Understanding these risks and choosing suitable investment strategies can help you make informed investment decisions.
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 |
Can you lose money in a mutual fund?
Mutual fund investments are subject to market risk, and there is always the potential for loss of principal. Market volatility, economic downturns, global events, and sector-specific difficulties can all cause the value of a mutual fund to fluctuate. In debt funds, rising interest rates can lead to bond price declines and potential losses. Additionally, credit risk arises if the fund's issuers fail to make payments. Poor fund management decisions can also contribute to underperformance. Investors should carefully consider their risk tolerance and investment objectives before making any investment decisions.
Risky funds that you can avoid
While diversification can help mitigate risk, certain types of mutual funds are inherently riskier than others. Understanding these funds can help you make informed investment decisions and avoid unnecessary risks.
Balanced Hybrid Mutual Funds
Balanced Hybrid Mutual Funds are investment vehicles that combine both equity and debt investments within a single fund. These funds are structured to cater to the diverse needs and risk appetites of investors by offering different combinations of equity and debt. The allocation of assets within the portfolio determines the level of investment risk, with varying degrees of exposure to market fluctuations. However, despite the potential benefits of diversification, taxation can present complexities due to the fund's investment mandate. For instance, Balanced Hybrid Funds investing predominantly in debt may be taxed differently from those with higher equity exposure, adding a layer of consideration for investors.
Read more about: What are balance funds?
Fund of Funds
A Fund of Funds (FoF) operates by investing in a portfolio of other Mutual Funds rather than individual securities. This approach allows investors to gain exposure to a diverse range of asset classes and investment strategies without directly managing multiple funds themselves. However, this convenience comes at a cost, as FoFs typically incur higher expense ratios to cover management expenses associated with selecting and monitoring underlying funds. From a taxation standpoint, investors are subject to tax upon redemption, with capital gains deductions applicable. It's worth noting that dividends received from FoFs are exempt from taxation, offering a potential advantage for investors seeking tax-efficient investment vehicles.
Sector Mutual Funds
Sector Mutual Funds are specialized funds that focus on specific sectors of the economy, such as utilities, energy, or infrastructure. By concentrating their investments in a particular industry or theme, Sector Funds aim to capitalise on opportunities within that sector. However, this focused approach comes with inherent risks, as the fund's performance is heavily influenced by the performance of the chosen sector. Additionally, the lack of diversification inherent in Sector Funds amplifies the risk profile, making them more susceptible to market volatility and sector-specific challenges.
Small Cap Funds
Small Cap Funds are Mutual Funds that primarily invest in equity or equity-related instruments of small-cap companies. These companies are defined by SEBI as those ranked below the 250th position in terms of market capitalisation. Small Cap Funds offer investors the potential for aggressive growth, as smaller companies often have greater room for expansion. However, this growth potential comes with increased risk, as small-cap stocks tend to be more volatile and sensitive to market fluctuations. Furthermore, the performance of Small Cap Funds is closely tied to the movements of their underlying benchmark, making them susceptible to market conditions.
Read more about: What is a small-cap mutual fund?
Credit-Risk Mutual Funds
Credit-Risk Mutual Funds are debt funds that invest in low-credit quality debt securities, offering potentially higher returns but with increased risk. These funds typically target bonds or other fixed-income instruments issued by entities with lower credit ratings. While Credit-Risk Funds may provide attractive yields, they also carry a heightened risk of default or credit downgrade. Investors with a medium-to-high risk tolerance in debt investments may find these funds suitable for their portfolio, but it i essential to carefully assess and monitor the credit quality of the underlying securities to mitigate potential losses.
Conclusion
Effective risk management is paramount in mutual fund investing to achieve long-term financial goals. Strategies such as diversification, Systematic Investment Plans (SIPs), and regular portfolio reviews can help mitigate market volatility. Additionally, aligning asset allocation with individual risk tolerance and seeking expert financial advice can provide tailored solutions. By implementing these principles, investors can prudently manage risks while pursuing sustainable wealth growth. A proactive and informed approach to risk management ensures that mutual fund investments are better equipped to generate consistent returns and navigate potential market downturns.
