Is there any mutual fund with zero risk?

Before this question can be answered, it is important to understand the type of Mutual Funds. Broadly, depending upon which instruments the fund invests in, mutual funds can be categorized into the following two types:

(a) Equity Funds

(b) Debt Funds

Equity markets are inherently volatile. A stock index never moves in a straight line, so investors need to be ready for the volatility. Equity schemes have Market Risk, which is the risk of the Net Asset Value (NAV) of the scheme going up and down along with the stock market. They are also exposed to Fund Manager Risk, which is the risk that the fund manager will underperform as compared to the benchmark.

Investment in Debt-oriented Funds held by non High Net-worth Individuals (HNI) and Retail Investors have seen a 40% increase as on March 31, 2017, to touch Rs. 67000 crore. This is a combined result of bank interest rates falling, more efforts concentrated towards creating awareness about the efficiency of Mutual Funds and easing the process of investing in Mutual Funds. While most investors are aware of the risks that Equity Funds carry, many investors believe that investment in debt funds is safe.

Return on Debt Funds is earned by way of interest. Interest is the reward you get for postponing your consumption, taking care of the effects of inflation on the money you get back and for the risk of the borrower not returning your money.

All Debt-oriented Mutual Funds are exposed to at least the following 3 risks:

(i) Interest Rate Risk: It represents the risk of the Fund Manager's interest rate estimations going wrong. Bond prices and interest rate are inversely related; meaning a fall in interest rate implies an increase in bond prices. However, if the fund manager's anticipation of interest rate goes wrong, your investment will perform worse as compared to others' whose fund manager took the right call.

(ii) Credit Risk: It represents the risk that the borrower will default on the payment. If your funds are given out as loans by mutual fund house to firms who default on repayment of its principal or interest, the value of the fund suffers. There have been three instances in the debt fund market in the past few years when the credit risk affected the investors' returns.

(iii) Liquidity Risk: It represents inability of the mutual fund house to meet the redemption requirements of the investors. When a borrower defaults on the payment or some adverse event occurs which hampers the liquidity of the fund, the investors are negatively affected. This is because there is lack of a markeet when you want to exit. The non-government Indian bond market is not very liquid, that is, fund managers may not find buyers if they need to sell in distress.

An investor must fully understand the risks inherent in Mutual Funds and then accordingly make a decision that best meets his goals.

Ever paid attention to these lines of advertisements of mutual fund companies - “Mutual funds investments are subject to market risk. Please read the offer document before investing “.  This disclaimer is mentioned in every advertisement of the mutual fund. It implies there is nothing like zero risk in mutual funds. However, there are various debt funds available which provide low risk to investors.

Mutual funds can be categorized into three categories on the basis of the risks:

High Risk Funds:  These funds are the equity oriented funds with high return expectations.  The expected rate of return for these funds is above 12 %. Many funds are providing as high as 20 % returns and some even to the extent of 30 %.

Low Risk Funds:  These funds are the debt oriented funds with low return expectations of around 6-9 %.

Medium Risk Funds:  The funds which provide medium level of risk are the combination of equity and debt funds can be called hybrid funds. They have expected return rate in the range 9- 12 %.

Risk and returns go hand in hand, when the risk gets lower so does the returns.  If the risk appetite of an investor is low, liquid funds are considered the safest. Liquid funds are the mutual funds which invest minimum 95% of the investors’ money in liquid instruments that gives a fixed interest for a particular period of time. The NAV of these funds is not very volatile which reduces the risk. However the returns from these funds are still higher than Fixed Deposits or Recurring Deposits of banks.

While investing in liquid funds, one should not go for the higher return record of the fund. The other factors such as average maturity period (lower the better), credit quality, etc should be considered.  Risk is something which needs management not avoidance. The overall risk in mutual funds can be minimized by investing in multiple funds.

Although liquid funds are a safe option for investors from the point of view of volatility and risk of losing capital, it is important to invest them in the right time horizon so that one doesn’t suffer from opportunity loss.