High risk equates to high profits. This phrase must have appeared frequently to you if you are an investor. In essence, it suggests that if an investment is promising a large return, it is likely also carrying a high risk. In the case of mutual funds, the same holds true as well. Risk-return profiles for various mutual funds vary. When compared to other categories, there are some mutual fund categories that may offer better returns. They do, however, also pose a greater risk.
What Are Mutual Funds?
A mutual fund is a sort of investment vehicle in which funds are gathered from numerous individuals and pooled together to invest in various securities, such as bonds, equities, and/or money market securities. By properly allocating the assets of the mutual fund and attempting to generate returns for investors, fund managers run mutual funds.
An investor might decide to put money into a mutual fund for a number of reasons. Mutual funds, for example, are normally traded once daily at their closing Net Asset Value (NAV) and have a low initial minimum investment requirement, making them reasonably accessible to most investors. Mutual funds have the additional benefit of being managed by a group of experts in the background. To accomplish the mutual fund’s investment objective, actively managed funds’ fund managers make stock, bond, and other security decisions based on market opportunities and other techniques.
Furthermore, diversity is a feature of mutual funds. You don’t put all your eggs in one basket when investing in a mutual fund because most of them have a tendency to own a variety of securities, which lowers the risks involved with investing in a single security.
Mutual Fund Riskometer
The Securities Exchange of India (SEBI) has assigned the six colours of the riskometer to evaluate the risk in various MF schemes. It aids novice investors in comprehending the level of capital loss in each scheme, allowing them to select the appropriate fund based on their individual objectives and risk tolerance.
They may be categorised as:
- Low-Level Risk
- Moderately Low-level risk
- Moderate-Level Risk
- Moderately High-level risk
- High RiskMutual Fund
- Very High-Level Risk
Risk Associated With Mutual Funds
- Market Volatility
We’ve all seen the one-liner in commercials stating that mutual funds are susceptible to market risk. Market risk is a risk that can result in losses for any investor due to the market’s bad performance. There are numerous things that influence the market. Natural disasters, inflation, recession, political upheaval, interest rate fluctuations, and so forth are a few examples. Market risk is often referred to as systematic risk. Diversifying one’s portfolio will not help in these situations. The only thing an investor can do is sit back and wait for things to fall into place.
- Concentration Risk
Concentration generally refers to concentrating on a single task. Concentrating a significant portion of a person’s money in one scheme is never a wise idea. If you’re lucky, your profits will be enormous, but your losses will be noticeable at times. Diversifying your portfolio is the best strategy to reduce this risk. Concentrating and extensively investing in a single industry is also risky. The lower the risk, the more diverse the portfolio.
- Risk of Interest Rates
Interest rates fluctuate according to the amount of credit available from lenders and the demand from borrowers. They have an inverse relationship. An increase in interest rates throughout the investment period may cause the price of assets to fall.
For example, suppose a person desires to invest Rs.100 at a rate of 5% for x years. If the interest rate rises to 6% for any reason, the individual will no longer be able to recoup his Rs.100 investment because the rate is fixed. The only option here is to reduce the bond’s market value. If the interest rate falls to 4%, the investor can sell it for more than the amount invested.
- Risk of Liquidity
The inability to redeem an investment without experiencing a loss in the instrument’s value is referred to as liquidity risk. It might also happen when a seller cannot locate a buyer for the security. The lock-in period of mutual funds, such as ELSS, may result in liquidity risk. During the lock-in time, nothing can be done. In another scenario, exchange-traded funds (ETFs) may experience liquidity risk. ETFs, as you may know, can be bought and traded on stock markets just like shares. You may be unable to redeem your investments when you need them the most due to a dearth of purchasers in the market. The easiest approach to avoid this is to maintain a varied portfolio and carefully select the fund.
- Credit Risk
Credit risk occurs when the scheme’s issuer is unable to pay the promised interest. Rating organisations typically grade investment agencies based on these factors. As a result, a person will constantly notice that a company with a good rating will pay less, and vice versa. Credit risk also affects mutual funds, particularly debt funds. In debt funds, the fund manager is required to include only investment-grade assets. However, in order to obtain larger returns, the fund manager may add lesser credit-rated securities. This would raise the portfolio’s credit risk. Examine the credit ratings of the portfolio composition before investing in a debt fund.
Categories of Risky Mutual Funds
- Sectoral and Thematic Funds
A Sectoral Fund is an equity fund that invests at least 80% of its assets in companies in the same industry. For example, technology funds will invest 80% of their assets in technology companies such as Infosys, TCS, and others. Because the portfolio will be less diversified, the risk will rise. The performance of the funds will be determined by the performance of the equities in that sector. Similarly, Thematic Funds are equity mutual funds that invest in stocks that are related to a specific theme. At times, the theme can be fairly specific, such as healthcare, energy, and so on. That is, they are just as risky as sectoral funds. Some Thematic Funds, on the other hand, follow broad themes such as ESG, business cycle, and so on. These are so diverse that their portfolio is comparable to that of any other diversified fund. And you don’t really have anything special to give. Overall, diversified equities funds that invest across sectors and themes are preferable.
Top performing industries have historically changed relatively regularly. Not a single Index has ever remained at the top for an extended period of time. As a result, including a Sectoral Fund raises the risk in the portfolio because your overall exposure to the sector may be greater than your risk tolerance level. Furthermore, evidence reveals that not every industry will perform well every year. As a result, Sectoral Funds are typically employed by investors for tactical allocation, or to capitalise on a specific opportunity. As a result, you should understand when to enter and quit the sector. Avoid Sectoral Funds if you don’t have the time or skills to do so. And don’t be concerned about missing out on profitable sectors. Diversified equities fund managers (Large cap, Mid cap, Flexi Cap, etc.) include such sectors and stocks in their portfolios when they are predicted to do well.
- Small-Cap Funds
Smaller companies may have the ability to expand faster than mid and large-cap companies. This is why small-cap stocks typically outperform large-cap and mid-cap enterprises during market rallies. However, they are likely to be affected harder during market downturns. As a result, they are highly unstable in comparison with mid- or large-cap companies over the long term. As a result, it may not make sense for ordinary investors until they understand when to enter or exit a small cap. That is, taking tactical positions in a Small Cap Fund may make sense. It will be tough for you to accomplish so without the assistance of a financial advisor.
As a result, when constructing your equity portfolio, preserve a high allocation to large-cap-focused funds and invest a smaller potion in small-cap funds.
- Credit Risk Fund
These funds, as the name implies, take on credit risk. That is, they buy papers with a significant chance of principal loss. Credit Risk Funds are required to invest at least 65% of their net assets in securities with lower credit ratings. These funds often have credit ratings of AA or lower, with AAA being the highest. The fund management purchases these bonds or debt papers because they have higher coupon rates, resulting in larger returns for investors. Furthermore, if the paper’s rating improves, there is a probability of capital appreciation because the bond price in which the mutual fund has invested appreciates.
However, things might not go as planned for the fund manager. We witnessed that following the IL&FS crisis, several funds were heavily damaged due to company failures due to the liquidity crunch. Some of the funds sustained significant losses. The goal of debt investment is to create portfolio stability. You don’t want to lose your principal if you invest in a debt instrument. As a result, it is preferable to avoid this category if you are a conservative investor.
Instead, you might invest in shorter-term funds such as liquid funds. If you plan to invest for the long term, you can also invest in medium to short-term debt funds (for example, short-duration funds, corporate bond funds, banking and PSU bond funds).
- Long-Duration Funds
These funds must invest in debt securities with a maturity of at least seven years. Long-term paper prices are more susceptible to changes in interest rates. As a result, as interest rates rise, the prices of bonds owned by these funds fall, resulting in a negative NAV.
This is what we are currently witnessing. Because the Reserve Bank of India (RBI) hiked interest rates this year, the category average return of Long Duration funds has fallen by roughly 2% year to date (January to July). These funds have also provided double-digit returns during periods of dropping interest rates, but when the interest rate cycle changes, they are likely to be hurt more than funds invested in shorter-duration securities. As a result, investors must time their entry and exit from these funds, which may be difficult for individual investors. As a result, if you are unable to do so, it is best to avoid funds in this category.
Target maturity funds are an alternative to long-term debt funds. Target Maturity Funds are index-based passive funds that invest in bonds based on the composition of the underlying index, such as the NIFTY SDL or the NIFTY PSU bond. Target Maturity Funds have a set maturity date, which is mentioned in the scheme name and practice. These funds invest in bonds that are constituents of the index they follow and have similar maturity dates. These bonds are typically held until maturity. In principle, you will be paid back your investment as well as interest. However, like with all mutual fund schemes, the principal is not guaranteed, so investors must consider this risk.
- Balanced Hybrid Funds
Hybrid Funds are, as the name suggests, a blend of equity and debt assets designed to achieve the scheme’s investment objective. Each Hybrid Fund has a unique mix of equity and debt that is tailored to a specific type of investor. The investment risk of Hybrid Funds is proportional to the asset allocation of their portfolio. Therefore, it is essential to thoroughly examine the scheme’s portfolio in order to comprehend the risks involved. For instance, if you are investing in an Equity-Oriented Hybrid Fund, you must consider the equities held by the fund. Are they predominantly Large-Cap or Small-/Mid-Cap? This helps you better comprehend the hazards.
Conclusion
Mutual Fund Investment cannot be risk-free, but if you know what you’re doing you can choose mutual funds which are aligned with your risk appetite. When investing in equity funds, investors should not be concerned with temporary fluctuations in the market. Choose a Mutual Fund that matches your investing goals and invest with a lengthy time horizon.
Everyone is not a suitable fit for every Mutual Fund. Prior to making a decision, consider all important criteria as well as your financial objectives to determine which Mutual Fund is appropriate for you. Before making an investment, it is recommended that you undertake research and learn more about mutual funds.
FAQs
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Why do mutual funds carry such a high degree of risk?
Mutual fund investments are inherently risky because they invest in a variety of financial products, including debt, stock, and corporate bonds, among others. Due to the tendency for the prices of these investment products to vary in reaction to multiple variables, investors may incur a loss. It is primarily due to the decline in the NAV of these investments. However, investors in Mutual Funds can maximise the risk-reward relationship of the investment vehicle by analysing the risk associated in Mutual Funds beforehand.
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