Whenever you plan to invest in mutual funds, a term ‘risk’ is often used. The higher the returns, the higher the risk. All investments are subject to some kind of risk, isn’t it?

Mutual Fund investments are less risky as compared to direct investment in equity, but riskier than Bank Deposits. The degree of risk in mutual funds differs from one scheme to another.

This can be due to the investment portfolio, management and how underlying investments are affected by micro and macroeconomic conditions.

Mutual Funds are of various types, depending on the risk involved. The composition of the mutual funds vary, depending on the proportion of equity, debt and cash.

 

What are the Risks??

Risk is innate to investing. Investments are of diffrent variety across the risk categories, but there is barely any investment that is completely risk-free.

An investment that is vulnerable to change in either direction is considered to be very risky. Both equity funds and debt funds have risk.

In order to judge the inherent risk in mutual funds, the most common tool is the riskometer. All mutual funds have a riskometer, which pinpoints the risk of investing in the fund.

Balanced mutual fund schemes are the least risky, as they can invest as much as 35 % of their assets in debt. Since large cap company’s price do not fluctuate drastically, they come next.

Mid and small cap companies are subjected to drastic changes, so the funds investing in them come at the second last place. Finally, since thematic and sectoral mutual fund schemes take highly theme specific bets, they are the riskiest of all.

With debt funds, the risks involved are interest risk and credit risk. Interest risk means that interest rates may increase or decrease unanticipatedly. Debt funds are not as risky as equity funds. Equity tends to be more volatile, especially in the short to medium term.

An increase in interest rates results in a fall in bond prices and vice versa. So, a scheme that has long tenure bonds is subject to high risk. Credit risk is the risk of default by the bond issuer. Debt funds that invest in comparatively lower rated paper have this risk.

There are other risks also in these funds, which the investor can reduce by making the right decisions.

What are the Types of Risks?

Most mutual funds are not assured, an investor might lose money over what he has invested. So, the immensity of risk in a mutual fund scheme is subjected to where the fund manager invests in.

Depending on the investment objective and category, a mutual fund scheme can be subject to any or all of the following risks which could impact the scheme’s performance.

  1. Market Risk

The prices and the income generated by the scrips held by mutual fund schemes may fall in response to few events, including those directly involving the companies whose scrips are owned by the funds. Generally, economic and market conditions, regional or global economic instability, or currency and interest rates change.

  1. Credit Risk

The risk that a security’s issuer is not able to meet his/her obligation in full and/or on time. Such as, payment of interest or repayment of capital or any other financial or legal obligation.

  1. Interest Rate Risk

The risk that an investment’s value will fluctuate due to a variation in the absolute level of interest rates.

  1. Liquidity Risk

This is the risk from the lack of marketability of an investment that cannot be rapidly purchased or sold to convert in cash.

Certain holdings may be difficult or impossible to sell at the right time. The mutual fund may therefore be forced to sell a holding at a lower price, or let go of an investment opportunity due to a liquidity problem. This could have a negative impact on the scheme’s performance.

What are the Risks of a Mutual Fund?

Risks of Debt Mutual Fund

Interest Rate Risk

When interest rate increases, the price of bonds decrease. Which means, an investor can lose investment value. So, an investor has to invest as per the interest rate change

Credit Rate Risk

Bond mutual funds are dependent on debt products. They are rated on the basis of criteria, such as safety, quality, returns and liquidity. If the quality of debt products which are part of the mutual fund scheme is inadequate, an investor can lose his money. If the bond issuer does not make the payments, the mutual fund scheme loses value.

Risks of Balanced Mutual Funds

Higher exposure to Equity

Few fund managers, in the hope of better returns raise exposure to equity and sometimes too volatile an equity. This can backfire and the fund can lose value.

Debt Holdings

If the fund has long tenure bonds and the interest rates increase, the fund can lose value.

Risks of Money Market Mutual Funds (Liquid Funds)

This scheme falls under low-risk category mutual fund but not risk-free. Normally, they do not play on credit risk but in the past, we have seen some of the fund houses were impacted negatively by trying to do this.

Inflation Risk

If inflation is greater than money market returns, investor’s investment loses value.

Opportunity Loss

An investor will probably get better returns if he invests in the right equity funds, or even other debt funds instead of money market funds. This results in opportunity lost.

Risks of Equity Mutual Funds

Volatility Risk

Most of the investment in an equity mutual fund is in equity and equity-related products. If the market is volatile, there can be changes in the NAV value. If the underlying stocks lose a lot of value, then the NAV will reduce.

Performance Risk

Return on Investment in equity funds is less when the market is not doing good, unless the fund manager manages the portfolio very well.

Concentration Risk

If a large part of the portfolio is in one scrip, or one sector, there is a risk of higher losses in case that scrip or the sector underperforms. Sector or thematic scheme can face this risk.

Risks of Close-end Mutual Funds

In every bull market, mutual fund companies behave like asset compilers, instead of asset managers. In 2007, they purchased a flood of close-ended NFOs (New Fund Offers).

Risk in a Mutual Fund SIP

Systematic Investment Plans (SIPs) are a way to invest in Mutual Fund schemes. SIPs are good for regular investment and cost balancing. It is also beneficial for people who cannot invest a lump sum amount.But the SIP method of investment is not a sure shot way to get high returns.
Risks Associated with a Fund Manager

If the fund manager commits mistakes and does not read the market correctly or is not proactive enough to manage the fund to avoid lesser returns, investor’s investment will suffer. A lot of times, proactive fund managers generate greater risk for their investors.

The fund manager cannot always manage or anticipate risks due to political conditions and local or global macroeconomics. In such circumstances, the fund returns might suffer.

Risk-Adjusted Returns

It shows the mutual fund scheme’s returns by measuring how much risk is generated in that return. It is defined as a rating or a number. There are formulae to calculate risk-adjusted returns.

Measurement of Risk

There are different ways to measure the risk associated with a Mutual Fund scheme:

1) Alpha: It gives a sign of how much returns the Mutual Fund scheme gives in relation to the benchmark associated with it. A negative alpha indicates that the Mutual Fund scheme underperformed by that figure relative to the benchmark.

2) Standard Deviation: It is a measure of difference from the average returns. For example, if the average returns is 14 % and the standard deviation is 2 %, it means the returns can deviate by 2 % on the positive and negative side. So here the returns can range from 12 % to 16 %.
The higher the volatility, the higher the standard deviation and higher the risk.

3) Sharpe’s Ratio: This ratio gives the information of how much better has the mutual fund scheme performed relative to risk-free investments. An investor can know how much he has earned by taking the risk.

4) Beta: It shows the sensitivity of the mutual fund scheme to the market movements or the benchmark. The Beta of the benchmark or market is taken as 1. If the Mutual Fund scheme has Beta less than 1, it is less volatile and if it is more than 1, it has more volatility relative to the benchmark or the market.

There are many other ratios but these are most commonly used.

Risk and Return Comparison of Funds:

Below mentioned are few funds from different categories of the funds we mentioned above. The type of risk involved in each of the funds along with their returns over different investment duration has been mentioned so that an investor can himself compare and decide which fund to invest in and for how long.

Balanced Funds 

HDFC Balanced Fund

Risk Moderate
Expense Ratio 1.98 %
Fund size 19169 Cr
1 year Return 17.75 %
3 year Return 11.35 %
5 year Return 19.27 %

 

ICICI Prudential Balanced Fund

Risk Moderate
Expense Ratio 2.19 %
Fund size 25957 Cr
1 year Return 14.89 %
3 year Return 11.19 %
5 year Return 18.47 %

 

Birla Sun Life Balanced 95 Fund

Risk Moderately high
Expense Ratio 2.27 %
Fund size 13595 Cr
1 year Return 13.74 %
3 year Return 9.53 %
5 year Return 17.05 %

 

Reliance Regular Savings Fund

Risk Moderately high
Expense Ratio 1.97 %
Fund size 11334 Cr
1 year Return 18.49 %
3 year Return 11.31 %
5 year Return 17.41 %

 

SBI Magnum Balanced Fund

Risk Moderate
Expense Ratio 1.97 %
Fund size 17955 Cr
1 year Return 17.75 %
3 year Return 9.65 %
5 year Return 17.45 %

 

ICICI Prudential Balanced Advantage Fund

Risk Moderate
Expense Ratio 2.23 %
Fund size 24228 Cr
1 year Return 12.19 %
3 year Return 9.27 %
5 year Return 14.53 %

 

Large Cap Funds

 SBI Bluechip Fund

Risk Moderately high
Expense Ratio 1.97 %
Fund size 17869 Cr
1 year Return 17.47 %
3 year Return 10.28 %
5 year Return 18.34 %

 

Mirae Asset India Opportunities Fund

Risk Moderately high
Expense Ratio 2.39 %
Fund size 6123 Cr
1 year Return 22.93 %
3 year Return 12.80 %
5 year Return 21.30 %

 

Reliance Top 200 Fund

Risk Moderately high
Expense Ratio 1.98 %
Fund size 4149 Cr
1 year Return 22.67 %
3 year Return 9.58 %
5 year Return 18.53 %

 

Mid Cap Funds

 HDFC Mid Cap Opportunities Fund

Risk Moderately High
Expense Ratio 2.26 %
Fund size 20959 Cr
1 year Return 20.68 %
3 year Return 15.54 %
5 year Return 26.89 %

 

Mirae Asset Emerging Bluechip Fund

Risk Moderately High
Expense Ratio 2.46 %
Fund size 5364 Cr
1 year Return 22.83 %
3 year Return 19.41 %
5 year Return 31.15 %

 

L & T Mid Cap Fund

Risk High
Expense Ratio 2.17 %
Fund size 1323 Cr
1 year Return 29.33 %
3 year Return 18.64 %
5 year Return 30.05 %

 

Aditya Birla Sun Life Pure Value Fund

Risk High
Expense Ratio 2.35 %
Fund size 1456 Cr
1 year Return 29.21 %
3 year Return 18.58 %
5 year Return 30.10 %

 

Birla Sun Life Small and Mid Cap Fund

Risk High
Expense Ratio 2.4 %
Fund size 1866 Cr
1 year Return 28.93 %
3 year Return 19.77 %
5 year Return 28.30 %

 

Principal Emerging Bluechip Fund

Risk High
Expense Ratio 2.37 %
Fund size 1625 Cr
1 year Return 26.75 %
3 year Return 16.51 %
5 year Return 27.97 %

 

Small Cap Funds

 Reliance Small Cap Fund

Risk High
Expense Ratio 1.99 %
Fund size 6371 Cr
1 year Return 41.82 %
3 year Return 23.03 %
5 year Return 36.71 %

 

HDFC Small Cap Fund

Risk High
Expense Ratio 2.38 %
Fund size 2152 Cr
1 year Return 44.19 %
3 year Return 21.21 %
5 year Return

Franklin India Smaller Companies Fund

Risk Moderately High
Expense Ratio 2.43 %
Fund size 7497 Cr
1 year Return 24.89 %
3 year Return 16.61 %
5 year Return 30.41 %

 Conclusion

It is advised by experts that the longer an investor invests for, the better it is.

This is because it has been seen over the years that the returns are justified with the risk that an investor is taking if the amount is invested for a long-term tenure of 5 years or more.

More the risk involved in a fund more should be the tenure of investment.

Happy investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.