Even before you started investing in mutual funds, you would have heard “Mutual funds are subjected to risk”
Ofcourse mutual funds have grown exponentially in the past few years and the investor base has increased tremendously, but there are a few risks about which investors should be aware of!
For example, due to the IL&FS Crisis, the infrastructure sector funds saw a downfall
Now, because of the popularity of mutual fund investment growing, most of us want to invest in these schemes as we feel these options fare better over investing in government securities like fixed deposits or risky investments like the stocks
Which is the reason that the average asset under management of the mutual fund industry in India has grown to ₹24 lakhs crores by January 2019.
In this article, we will look at the 6 major risks associated with mutual funds.
Let’s now concentrate on the types of risks Mutual Funds
In this article
1. Market Risk
Most mutual funds are linked to financial markets in India.
For scenarios like the financial crisis in 2008, every market was hit by the slowdown. Eventually, mutual funds returns suffered as well.
Some mutual funds have exposure to foreign shares and bonds as well. If the economy of those countries deteriorates, the funds invested in this asset class will give negative returns.
Government reforms and economic conditions, along with other macro-economic factors drive the financial market conditions.
Scams due to governance, a non-sustainable strategy can hamper a sector badly as well. This dampening is then cascaded to the entire market.
2. Risk of Exiting a Scheme
This refers to the redemption of our investments from a mutual fund without incurring a loss. This is linked more to closed-end funds than open-end funds.
Typical closed-end funds have a lock-in period.
When we invest in such schemes and if by chance we need to exit our schemes, we cannot redeem our investments.
This may also occur over Exchange Traded Funds.
3. Sector Risk
Mutual Funds can be very specific according to the sector.
If the portfolio of stocks is not well diversified, you can be exposed to a single sector very prominently. This means your returns are strictly dependent on the performance of a few stocks or the entire sector.
Imagine if this sector is the pharmaceutical sector and the government passes norms in which the sector gets negatively impacted. Thus, the returns linked to this fund will also be impacted.
The diversification over here could be companies which have a majority of international operations and they derive at least 60% of the revenue from there.
4. Interest Rate Risk
This is linked with mutual funds that have a large exposure to fixed income securities or bond markets. The funds are debt fubds.
They can be either government bonds or corporate bonds. Prices of bonds are inversely related to interest rates prevailing in the country.
Hence, if due to an economic reform the interest rates increase, the price of bonds will decline. This will lead to loss during selling or redeeming in the bond market.
The good news can be when interest rates decline, it will lead to an appreciation of bonds and will drag returns to the positive side.
5. Credit Risk
Credit risk refers to the default situation when the issuer fails to pay the amount and premium which they had promised. This is again linked more to debt based mutual funds.
Imagine you are invested in a corporate bond fund, If this company defaults or goes bankrupt, there is a possibility of massive loss. Though, time delays are guaranteed in such situations.
Generally, fund managers should invest in investment grade debt funds, but in order to make large returns, they might resort to lower credit rated companies or institutions.
6. The Risk of Frequent Rebalancing
The fund manager periodically re-balances and monitors the investments daily. This is the reason why the fund houses sends you regular reports regarding investments the returns.
Now if the mutual fund frequently rebalances your portfolio, it might not fare well for the investor and the money will not have an opportunity to grow.
Therefore, it is always recommended to keep an eye on the activity of the fund and review it from time to time.
Why Do Investors Prefer Mutual Funds?
1. Leave it to the Professionals
Firstly, mutual funds are convenient.
An investor does not need to keep a check on his/her investment as professionals are already managing. Which is not quite the case with direct stocks.
Come hail, rain or storm, the fund manager and his/her team will take the most calculative decision for you!
3.Less Volatile Compared to the Stock Market
Mutual funds have a well-diversified portfolio.
Hence, if we consider a case in which we invest ₹10,000 over a year in say 5-6 stocks and invest ₹10,000 in mutual funds. The returns would be closed from the promised return watermark for mutual fund investors over stock investors.
Thus, if the market crashes, stock market investing is hit worse, as compared to Mutual Funds as these Mutual Funds are well diversified.
4. Suit Yourself
Nowadays many mutual fund houses provide various mutual fund solutions to suit investor’s risk appetite. These funds can be high on government bonds, or government-backed investment vehicles.
Or the funds can be of a high-risk high return type, like small-cap equity funds.
Thus, for every risk appetite, there is an equivalent mutual fund present.
Mutual funds are investment vehicles which come with a varying degree of risk. As discussed, the above risks are likely to get associated with any portfolio or mutual fund type we invest.
But with slight research, you can select the best mutual fund for yourself.
Disclaimer: The views expressed in this post are that of the author and not those of Groww