Risks associated with Mutual Funds


Posted By : Kushal Kothari
Tags :  Risks

Mutual Fund investments are subject to market risks - We all know this universal disclaimer that follows each radio ad, newspaper ad and is mentioned in all policy documentation of mutual funds, right? We are so repetitively exposed to these words that we start taking them for granted every time we hear them. It sort of ends up beating the purpose.

The problem is, that the product distributors have to sound off their customers about risks involved in investments without scaring them away. And the customers are all too busy to read and understand the fine print when the main thing that matters is the expected returns from their investments. We've tried to summarize in brief what exactly are the risks involved in mutual funds and which ones you should care about in your portfolio.

 

There are broadly 5 risks that you need to know about with regards to your investments. We've explained them in their decreasing order of importance (in our opinion) - 

 

Market risk - This is the prime risk that exists across all kinds of mutual funds. Any security - be it equity or debt, is actively traded between market participants. The daily price of these securities fluctuates due to the demand and supply behaviour, which in turns depends on a host of macroeconomic factors. The bottom line is this - There will always be volatility in your portfolio. The NAV at which you buy or sell a fund, will be influenced by the buying and selling forces in the market. So accept daily fluctuations as a fact of our portfolio.

 

Credit Risk - This is the basis on which the entire business of lending is built upon. Investing in Corporate bonds, Fixed deposits, Govt Bonds, etc is nothing but lending money to another party - a corporate, a bank or the government respectively. Hence, just as in any lending arrangement, the first thing you need to be aware of is that of credit defaults. Defaults happen not only with corporates but even with governments. So even though one does his best to invest in credit worthy opportunities, credit defaults may still happen. Paying attention to credit ratings by various agencies helps. Regardless, remember that downgrades can happen overnight without much warning. The key thing is to manage the risk and limit the downside.

 

Interest Rate Risk - This is the mother of all risks, especially when it comes to debt securities. Without going into much detail - The price of a debt security depends on the 'expected' rate of interest till the time of maturity. The problem is that these expectations change as time passes by due to many factors such as monetary policy, inflations etc. As the interest rate expectations change, so do the price of these interest bearing securities. Prices may go up or down. The one thing to remember is - higher the average maturity of the security, the higher is the interest rate risk. So pay close attention to average maturity of your debt instruments. Since the price and interest rate are interlinked for debt instruments, the market risk and interest rate risk imply the same thing in different words.

 

Liquidity Risk - Perhaps you may know this, that when you redeem a mutual fund, it may take a couple of days to redeem your units. It depends not only on the amount but also on the category of the scheme that you are redeeming. Bluechips stocks are fairly traded to be easily sold off. Same might not be the case for small-cap stocks. The risk of not being able to sell your holdings when you want to is what is known as liquidity risk.

 

Currency Risks - Some of the funds invest in international markets - China, Japan, US etc. When they do, your rupees get converted to foreign currency to be invested in the foreign market. While redeeming, the foreign currency is again converted to Indian rupees to pay off the investor. Any fluctuation in the exchange rate during this process is what is called the currency risk. It not only exists in International funds but also with commodities such as gold and oil as their prices are impacted directly by the global prices.

 

Now that you have a brief idea about the kind of risks that exist with investments - Here's a table that helps understand the risks that may exist in your portfolio. We have selected the broader categories of funds for analysis here.

 

Risks associated with Mutual Funds
Type of Fund Market Risk Credit Risk Interest Rate Risk Liquidity Risk Currency Risk
Equity Funds          
Large Cap Yes NA NA No NA
Mid Cap  Yes (High) NA NA Maybe NA
Small Cap Yes (Very High) NA NA Yes NA
           
Debt Funds          
Liquid Yes (Low) Yes (Low) Yes (Low) No NA
Money Market/Ultra Short Term Yes Yes Yes Yes (Low) NA
Short Term Yes Yes Yes Yes (Moderate) NA
Long Term Yes (High) Yes Yes (High) Yes NA
Income / Dynamic  Yes (High) Yes Yes (High) Yes NA
           
Others          
International Equities Yes No No Maybe Yes
Gold Funds Yes No No No Yes

 

Hope this helps 

 

Happy Investing!