Risks Of Investing In Mutual Funds

Mutual funds is one of the great investment options that are available in the market. Mutual fund is a pooling together of money obtained from multiple investors which, after careful research, is invested in a variety of asset classes, such as equities, debt, money market instruments, etc. so as to maximise growth in capital.



Though mutual funds have great potential to generate good returns, these also come with risks. The risks depend on the the category of the fund. While investing in mutual funds, there are various parameters that should be taken into consideration and risk is one of the major factors that needs to be considered. Investors should understand the risks that is involved before investing in mutual funds, or any other products for that matter. Even SEBI (Securities and Exchange Board of India) have mandated the SEBI Registered Investment Advisors to assess the investor's risk profile before recommending any investment product. So, assessing your risk profile before investing is a wise thing to do. This will help you to choose products that suit your risk profile and requirements.

You may have come across many advertisements stating, “Mutual fund investments are subject market risks. Please read the offer document carefully before investing”. People usually relate this with the risks that are involved in stock market investments, as the disclaimer clearly states “market risks”, but are these the only risks involved while investing in mutual funds? Apart from the market risks, mutual funds are subject to many other risks. These risks have been listed below.



Equity Mutual Fund Risks

Volatility Risk
As we know, the NAV (Net Asset Value) of an equity mutual fund depends on the holdings of the underlying stocks in the fund. If the overall portfolio of the fund consists of volatile stocks, then the fund tends to be volatile. Volatility is nothing but the extent to which the price of any asset fluctuates. So, more fluctuations result in higher volatility, and in turn, higher risk. In short run, equity tends to be an highly volatile asset class, but over the long period, the volatility of equity reduces. Investors can reduce this risk over the long period of time by investing via the SIP (Systematic Investment Plan) mode. Using this, you would buy more number of units when the markets fall, and lesser number of units when the markets rise and eventually get benefited from the rupee-cost averaging.

Concentration Risk
A mutual fund may be subject to concentration risk, where the fund has a higher proportion allocated towards a single company or a single instrument or even a single sector. Thematic and sectoral funds are a perfect example of funds which, by default, carry concentration risk as they are particularly focused on one sector or one theme. Even the focused equity mutual funds may be carrying concentration risk to an extent as they invest in limited number of stocks, say 30 or 50, thereby allocating more funds towards a single stock or more often to a single sector. Not only equity mutual funds, but debt mutual funds also subject to concentration risk. Debt mutual funds may invest a high proportion of funds in a single debt instruments or in various debt instruments of a single company or in the same group of companies.



Debt Mutual Fund Risks

Interest Rate Risk
Debt mutual funds primarily invests in fixed income securities. The value of these securities depend on the interest rates prevailing in the market. Being inversely correlated, when the interest in the market falls, the prices of the debt instruments rise, and vice versa. To keep the inflation under control, the Reserve Bank of India (RBI) usually tweaks the repo rate. So, the interest rate hugely depends on the repo rate as decided by the RBI. If there is increase in the repo rate, then the value of the debt instruments tend to decline, and vice versa. However, in the short run, interest rates are often stable, but in the long run, interest rates tend to be volatile. This is why debt mutual funds are somewhat safe in the short term and usually volatile in the long run.

Credit Risk
Debt mutual funds are also subject to credit risk. When the debt instrument issuer defaults in the payments or is likely to default in the payments, such debt instruments are exposed to credit risk. As debt mutual funds invest in debt securities, these are also exposed to credit risk. Debt instruments with low rated papers usually carry high credit risk. Debt funds usually take these kind of calls to generate high returns.

Inflation Risk
Inflation risk is something which always works in the background and can also be categorised as systemic risk as it is unavoidable. However, this risk can be reduced to some extent with proper investment. Inflation risk is nothing but the risk that reduces your purchasing power. Even though we have segregated this risk as a risk for debt mutual funds, even equities can be subject to this risk. However, equity mutual funds have historically beaten inflation and have the potential to beat the inflation in future too, unlike debt mutual funds, which are usually more subject to inflation risk.

So, apart from the market risks, there are various types of risks that need to be taken into consideration before investing. Not just that, you also need to first assess your risk appetite before deciding where to invest. It is advisable not to just look at the returns that mutual funds have generated. You need to also look at the risk that the funds are carrying with them. Risk is equally important so far as returns are concerned. There are various parameters to gauge the risk of the funds, viz. alpha, beta, standard deviation, Sharpe ratio, Sortino ratio, Treynor’s ratio, credit ratings, etc. These factors would help you understand the risk the fund is taking to generate the kind of returns it is generating.

This is the tenth article of the knowledge series sponsored by Sundaram Asset Management Company, which will cover various topics important for your financial well-being.