Mutual funds have become the talk of the town off late owing to the higher returns offered along with benefits such as diversification, higher regulatory support, and the likes.
But have you understood the risk involved before you invest? In this blog, we seek to discuss the types of risks that are involved in a mutual fund. Knowing the risks shall help an investor make an informed decision.
Why is a mutual fund risky?
Risk arises in a mutual fund because it invests in securities such as equities, debt including corporate and government bonds, and the likes. These securities are volatile. They tend to fluctuate due to factors such as demand-supply, change in the interest rate from the central bank, inflation in the economy, and many more macroeconomic factors. Due to the fluctuation in the price of the securities, the Net Asset Value of the fund becomes volatile. For our novice readers, Net Asset Value (NAV) is nothing but the net market value of all assets in a scheme per unit.
Types of risks involved
We all have seen one disclaimer in the advertisement of mutual funds, which says – Mutual Funds are subject to market risk. Read the offer documents carefully before investing.
So what is the market risk here?
Market risk is the risk that may result in losses due to the poor performance of the capital market. Several factors may impact the performance of the market. These include – slowing growth of the economy, reducing per capita expenditure, rising inflation, the possibility of a recession, geopolitical tension, trade wars, and many more. Also, market risk is systematic risk, and thus diversifying a person’s portfolio may not help in such a scenario.
Every portfolio comprises of a basket of securities. Concentration risk arises when a handful of shares or securities account for a considerable portion of the portfolio. For example, around Top 5 stocks holding more than 60% of the portfolio is nothing but concentration risk as to the entire portfolio, in this case, is dependent on the five scripts.
The best way to minimize the risk is by diversifying the portfolio. Remember, over-diversification is terrible, too, and brings in risk.
Interest rate risk
The central bank changes the interest rate after taking stock of the economy. Based on the credit scenario of the economy, and inflation, the interest rates are determined, which is then flowed to the borrowers and lenders.
Change in interest rates impacts both equity and debt instruments. For example, interest rate and bond yield are inversely proportional. Similarly, if the interest rate is high, the corporates tend to reduce borrowing as it impacts profitability. Thus, interest rate risk forms an integral part of the mutual funds. Interest rate is generally tracked for debt funds, namely short-term, long-term, ultra-short-term, and the likes.
Liquidity risk refers to the difficulty an investor face while redeeming an investment. These risks may result in losses if the seller is unable to find a buyer.
In mutual funds, Equity Linked Saving Scheme (ELSS) that provides tax benefits under section 80C comes with a lock-in period of three years and thus faces liquidity risk due to the constitution of the fund. In another case, the exchange-traded funds or ETFs may face liquidity risk as these are bought and sold on the exchanges similar to that of shares.
The best way to mitigate such risk is to conduct proper due diligence and have a well-diversified and optimized portfolio.
Credit risk is more prevalent in debt schemes where the risk of default on timely payment and in full remains a concern for the bond issuer. The credit rating agencies rate the companies on the risk of default on the debt obligation. If the risk is high, the returns offered by the issuer of bonds (read companies) are high.
In debt funds, the fund manager is required to incorporate investment-grade securities. In some cases, it has been observed that the fund manager compromise on the credit rating to fetch additional returns. This results in amplified credit risk.
To sum up, nothing in the world is risk-free. As an investor (irrespective of the category such as retail, HNI, or corporate), you are required to conduct proper due diligence before investing. Conducting due diligence ensures that the investor is aware of the risks involved and doesn’t face any surprises in the future. Should you wish to know more about the due diligence process, fund selection, and even analyzing the risk for funds, let’s catch-up for a cup of coffee. We have our office in Ahmedabad. We are also available on email and social media – follow us there. In the meantime, check our app on iOS and Android.
Also Read: Types of Mutual Funds in India