Mutual Funds – Risks


All investments are subject to some risk. 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 the underlying investments are affected by micro and macroeconomic conditions.

Risks associated with Mutual Funds

1. Credit Risk/Default Risk:

Fund Managers take this risk to get higher returns by investing in lower quality papers, like AA, A+, etc. Credit risk is the chance that a bond issuer will not make the coupon payments or principal repayment to its bondholders. In other words, it is the chance the issuer will default. Higher this chance, higher will be the yield/return on the paper. Judicial prudence has to be applied before taking this call. Recent events have brought this risk to fore front. IL&FS, Essel Group, Jindal Group, DHFL, etc. Some of the cases where downgrade and default happened and investors had to bear the burnt.

2. Liquidity Risk:

This is a risk that an investor might not be able to sell his or her corporate bonds quickly due to a thin market with few buyers and sellers for the bond. Lower quality paper has lesser liquidity and vise -Verse. During distress times in bond market liquidity dries up and not many buyers are available as a result selling of bonds becomes difficult and it has impact of returns.

3. Interest Rate Risk

Fall / rise in interest rates have inverse impact on the NAV of debt schemes. Debt Schemes with longer maturity papers have higher impact of fall in interest rates and vice-verse. Such risk can be mitigated by investing in shorter maturity papers.

4. Market Risk

Market risk is basically a risk which may result in losses for any investor due to a poor performance of the market. There are a lot of factors which affect the market. A few examples are a natural disaster, inflation, recession, political unrest, fluctuation of interest rates. Market risk is also known as systematic risk. Diversifying a person’s portfolio won’t help in these scenarios. The only thing which the investor can do is waiting for the storm to calm.

5. Reinvestment Risk

This is another risk where once investment in a paper is matured and it has to be invested again in some other paper at lower / higher yield paper. Sometimes bonds are issued with call option, where issuers have the option to premature the bonds. In such scenario investors are left with no other option but to sit on cash or invest at prevailing market options, which could be good or bad.

6. Concentration Risk

Concentration generally means focusing on one thing. Concentrating a huge amount of a person’s investment in one particular scheme is not a good option. Profits will be huge if lucky, but losses will be more. Best way to minimize this risk is by diversifying your portfolio. Concentrating and investing heavily in one sector is also very risky. The morediverse the portfolio, the lesser the risk is.

7. Scheme Mismatch

Another important aspect is investors’ requirement and selection of Schemes. This is where most of the investors falter and make wrong selection. Selection should be as per his / her requirement or investment horizon. Right from overnight to liquid to ultra-short term to long duration or Dynamic funds, each category have different time horizons depending on its portfolio constitution and have different return potentials. Investment keeping in mind this aspect is equally important. Mismatch in this would leave a severe dent in investors return in case of distress in market, like that of current market conditions.

Ways and means to mitigate the Risks

  1. Have equity MF exposure within your risk tolerance.
  2. Ensure debt MF exposure is well spread out.
  3. Have adequate exposure to debt assets outside of MFs such as FDs, Govt bond such as PPF, POMIS, NSC, RBI Bonds etc.,

Should you invest in Mutual Funds?

Mutual Funds are safe. Investors should not be worried about short-term fluctuations in the returns while investing in them. You should just choose the right kind of mutual fund to match your investment goal and invest in it with a long-term view. Just as time heals everything, time also makes mutual funds safe and rewarding.
Before you invest though, it is always wiser to do your research and read more about Mutual Funds in general. Different funds will give you different returns based on their market performance and their historical graph. You can look up the Value Research Rating guide which ranks the top-performing Mutual Funds every year and takes your pick.

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