Overlooked Risks In MFs

There are various factors that one takes into account before investing in mutual fund, risk being one of them. DSIJ explores the various types of risks, other than ‘market risk’, you should be aware of before investing. 


You may have seen this disclaimer in many television advertisements or you may have even listened it on the radio. It states that “Mutual fund investments are subject to market risks, please read the offer document carefully before investing”. Most of the investors or general public associate this disclaimer with respect to the stock markets. They relate volatility involved in the stock market or risks involved by investing in stock market as market risk. But is it so? Is it the only risk involved when you are investing in mutual funds or are there other risks lurking around the corner that you should be aware of? Let’s find out. 

While investing in mutual funds, there are various factors or parameters one must take it into consideration and risk is just one of those factors to be considered before investing. It is very important for investors to understand the risks involved before investing in mutual funds, or any other products for that matter. Even SEBI (Securities and Exchange Board of India) has mandated the SEBI Registered Investment Advisors (RIAs) to assess the investor’s risk profile before recommending any investment product. So, it is very important to assess your risk profile before investing. 

There are various types of risks an investor must look for while investing in mutual funds. There are certain risks which are unavoidable even after diversification of your portfolio. On the other hand, there are risks which can be avoided with the help of investment in well-researched portfolio. Following are the different types of risks involved with investments is mutual funds. Out of the following, only the market risk cannot be avoided as these are systemic in nature. 

Market Risk Market risks, also known as systemic risks, are the risks which may result in losses due to poor performance of the market. There are a lot of factors which affect the market directly or indirectly. Some of the major macroeconomic factors such as non-general inflation, recession or political instability which cannot be avoided and will impact your investments. In addition to this, there are other risks such as natural calamities like floods, earthquakes, etc., which also impact the entire market. 

Market risk being systemic risk, portfolio diversification won’t help the investors in such situations. This is due to the fact that these are unavoidable situations and investors must wait for these situations to subside and stabilise. This is the risk that is most talked about and advertised in most of the investment products .

Concentration Risk The concentration risk is the risk that arises while investment is done focusing just on a single asset class or funds. It is not always a good idea to invest all your money into one asset class or one mutual fund, for that matter. This will increase the risk of your investment portfolio. This risk can be avoided by proper portfolio diversification. Investment in different asset classes in different proportions based on your risk profile would help you to avoid this type of risk. The more diversified the portfolio, the lesser the risk. More diversification doesn’t mean one must hold similar mutual funds. More efficient diversification can be achieved based on the different asset classes rather than individual mutual funds. 

In the short run though, a portfolio with higher concentration in one asset class may perform as and when that asset class performs well. Nevertheless, as returns of the asset class go in cycles, diversification in different assets will help to improve returns in the longer run. 

The concentration risk can best be gauged from the performance of hypothetical portfolio with different holdings during year 2008. 

The top five best equity diversified fund have generated a return of -41.15 per cent; however, the debt funds on an average have generated a return of 24.87 per cent. Therefore, if you would have only invested in equity, the best you would have earned is -41.15 per cent. However, if you had diversified your portfolio with debt, your total portfolio returns would have been much better.

The current situation is also reminiscent of year 2008 when the equity funds on an average generated negative returns in the last one year. However, debt funds of all durations and risks have generated positive returns in the last one year. 

Interest Rate Risk For most of the debt instruments, interest rate risk takes the lion’s share. Interest rate risk arises from the fluctuations in the interest rates, which depend upon the credit available with the lenders and the demand from the borrowers. In short, it depends upon the demand and supply of the credit, along with the general level of interest rate in the economy. If the interest rates fall, then the value of credit instrument increases and, on the other hand, if the interest rates rise, the value of the credit instrument falls. This happens due to the fact that borrowers want to borrow at low interest rates and lenders wants to lend at high interest rates. 

For example, you invest Rs.1,000 in a bond giving you a rate of interest of 7 per cent per annum for a period of 10 years. In case of a rise in interest rate, the value of your bond will diminish as there is an inverse relation between the interest rate and the price of bond. Similarly, in case of a fall in the interest rate, the value of your bond will increase. 

Liquidity Risk Liquidity risk means risk arising due to difficulty in converting a particular investment in cash without incurring any loss whatsoever. This risk occurs when the supply of the instrument is more than demand. Let’s take an example to make this clear. 

We assume that there are two investments, one is a 5-year FD (fixed deposit) of Rs.1 lakh (including interest of Rs.6,000) and a diversified equity mutual fund worth Rs.1 lakh. If you face an emergency and you urgently require Rs.1 lakh and if you had invested in FD of five years, then you cannot withdraw Rs.1 lakh, and if at all you decide to withdraw by breaking the FD, then you have to forego the interest of Rs.6,000 and you will only receive little more than Rs.94,000 as against the requirement of Rs.1 lakh. 

On the other hand, if you had invested in a diversified equity mutual fund or any other mutual fund for that matter (except equity-linked savings schemes and solution-oriented mutual funds), you would have received Rs.1 lakh. In the above example, other things such as taxation, fees and charges have not been taken into consideration. 

The above example clearly shows the importance of liquidity in investment. The easier and quicker the conversion of an investment into cash, the more liquid the investment. There are various assets which are considered illiquid such as real estate, gold, silver, stones, antiques, etc. 

Credit Risk Credit risk is the risk arising due to the lenders inability to make interest payments as promised. Generally, the companies that issue fixed income securities are assessed by the rating agencies which, after the company's credit assessment, give a particular rating to the credit instruments. The credit rating agencies such as ICRA (Investment Information and Credit Rating Agency Ltd.), CRISIL (Credit Rating Information Services of India Ltd.), etc. rate these credit instruments on their credit scale. The “AAA” rated (by ICRA or CRISIL) credit instruments are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk. On the contrary, the “D” rated (by ICRA or CRISIL) credit instruments are considered in default or are expected to be in default soon. 

Though these credit rating agencies are professional and provide ratings based on a thorough analysis of the credit instrument, they are not backed by the Government of India, which means that “AAA” rating provided by these rating agencies does not mean that the company will not default. Having said this, every credit instrument, apart from the ones that are backed by the Government of India; have credit risk embedded in them. Credit risk can be more evidently found in debt and debt-oriented mutual funds or any investment vehicle which invests in credit instruments. This risk can also be avoided with proper asset allocation based on an individual’s risk profile and portfolio diversification based on it.

Example of Credit Risk: In recent times, the rating agencies ICRA and CRISIL downgraded the non-convertible debentures of IL&FS (Infrastructure Leasing & Financial Services Ltd.) from AA+ to BB and short-term commercial papers of IL&FS subsidiary (IL&FS Financial Services Ltd.) from A1+ to A4 in shortest possible time. Around 25 mutual fund schemes held Rs.2,700 crore of bonds and commercial papers issued by IL&FS and its subsidiaries. Following are the list of some of the mutual funds which held the downgraded instruments of IL&FS and faced a fall in their NAVs. 

Risk comes from not knowing what you’re doing. 

– Warren Buffett 


Currency Risk The currency risk is another important risk factor to consider before investing in any asset. It is a risk which arises from the possibility of changes in the price of the country's currency in comparisons to the price of another currency. These risks affect many companies or sectors whose business depends directly or indirectly upon the import and export of final products or raw materials. Some of the sectors such as oil & gas, information technology, etc. would be affected by the currency fluctuations, and hence, may carry currency risk and also investment vehicles such as mutual funds that hold stocks of these companies in their portfolios would also get affected by the same. 

For example, let us assume today the USD/INR rate is 73.50 and there is one oil company which imports crude oil and other is an information technology (IT) company which exports its services. So, if the Indian currency strengthens to Rs.70.50 per dollar, then this will be a good news for the oil company as the company can buy crude oil at cheaper price, but it is bad news for the IT company as the company will be selling its services cheap. On the other hand, if the exchange rate falls to Rs.76.50 per dollar, then this would be a good news for the IT company as it would be getting more rupee for the same work and it would be bad news for the oil company as it would be paying more for same amount of crude. 

So, large mutual funds can be affected by currency risk as these funds may be invested in these companies, specifically certain sectoral or thematic mutual funds may be high on the currency risk due to their concentration in one sector. Also, the international mutual funds may also be affected due to the currency risk. 

Currency Risk Example:
 In recent times, the rupee has depreciated against the US dollar, so if we continue with our example the oil and gas sector in the past three months provided negative 11.46 per cent returns whereas IT sector provided negative returns of 4.23 per cent and, for the same period, the market gave negative returns of 9.14 per cent. From this, it can be seen that the IT sector outperformed the market, while the oil and gas sector underperformed the market. So, in the past three months, oil and gas companies and mutual funds holding stocks of these companies faced currency risk. The graph below clearly shows how the fall in the value of rupee has impacted different sectoral indices. 

Inflation Risk Inflation risk is the risk of your money losing its purchasing power as time passes by. This means that prices of things rise with time and you cannot buy the same thing at the same price in future. This is one of the major risks one needs to consider before investing. Your investment must at least match the pace of inflation, if not beat it. This risk can be avoided by proper financial planning and investment which is backed by certain financial goals. So, one must not invest any random amount in random mutual fund which can only give you a random output. It is always prudent to invest as per the financial plan that gives you the road-map as to where you are, where you want to go and how you would be able to reach there. This means investing based on amount that is required at a given point in time. This would help you choose proper investment options which would suit your requirements. 

As you can see, there is not just market risk which is involved in investment in mutual funds. So, mutual funds are not just subject to market risks, but also subject to concentration risk, interest rate risk, liquidity risk, credit risk, currency risk and inflation risk. In future, when you thinks of investing in mutual funds, it is good to consider all these risks as well before investing. Also, having a proper financial plan in place which would include the well-defined requirements, proper allocation of assets, required re-balancing steps and construction of a diversified portfolio will help you reach your financial goal


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