The main motive behind investing in any asset is to generate returns. Returns vary from investment to investment. Also, no investment is risk-free. All investments have different risks. Similarly, mutual fund investments are not risk-free. Though mutual funds are diversified investment options, they have certain inherent risks. This article covers different types of mutual funds risks in detail and certain risk-mitigating techniques.
Are Mutual Fund Investments Risky?
Mutual funds invest across different financial assets such as equity, debt, bonds, commodities, government securities, etc. Hence, the investments are exposed to different risks. The equity portion of the scheme witnesses market, liquidity, volatility, concentration risks, etc. At the same time, the debt portion comes with interest rate risk, inflation risk, credit risk, etc. Therefore, be it any type of instrument or asset class, the risk is inevitable.
As per SEBI’s regulation, every mutual fund defines the level of risk associated with the scheme through a Risk-o-meter. Equity mutual funds, credit funds and hybrid funds are considered to be moderate to high-risk schemes. At the same time, debt mutual funds are low-risk funds.
Investment risks are broadly classified as the following:
Systematic risk is a type of risk in mutual funds that is out of your control and affects most assets. For example, certain government announcements or regulations may have an impact on your investments. Since such regulatory decisions are not in your control, they are systematic risks.
The unsystematic risk or specific risk particularly affects an asset. For example, an unexpected fire breaks out, or workers strike is specific to a company. As a result, there would be an impact on the company’s stock prices.
Types of Risk in Mutual Funds
Following are the different types of risk in mutual funds:
1. Market Volatility Risk
‘Mutual fund investments are subject to market risk’ is a well-known disclaimer by all mutual fund advertisements.
Poor market performance results in losses. Multiple factors have an impact on market performance. For example, inflation, recession, interest rate fluctuations, political unrest, natural disasters, etc., have a significant impact on the market performance. The COVID-19 outbreak has affected the Indian markets in 2020. Indian markets have witnessed a significant crash. Market risk is a type of systematic risk. There isn’t much that you can do to address it. The best strategy is to wait the markets out.
2. Liquidity Risk
Liquidity risk is the risk of not being able to liquidate your investment at the time of need. Or, it is the difficulty in redeeming an investment without incurring any loss. ELSS is a tax saving mutual fund scheme with a three-year lock-in period. This lock-in period results in liquidity risk. You will not be able to redeem the fund units during the lock-in period.
Exchange Traded Funds (ETF) experienced another kind of liquidity risk. ETFs are traded on the stock exchange after their issue. Often it becomes difficult to find interested buyers or sellers of the ETF on the stock exchange. The trade volumes are low, and it might become difficult to exit in time of need.
3. Concentration Risk
Concentration risk refers to having high exposure to one particular asset or sector, or theme. For example, if your investment portfolio has high exposure to equity schemes, it means that you have a high-risk portfolio. When the markets are volatile, the probability of losing money is high. This is because of the high concentration in the equity scheme. To address this, you will have to adopt different diversification strategies.
4. Interest Rate Risk
The Reserve Bank of India revises interest rates from time to time. The interest rate changes have an impact on the price of a security. Interest rates and bond prices are inversely related. If there is an increase in the interest rates, the bond prices fall. Similarly, if the interest rates decrease, the bond prices increase. Therefore, changes in interest rates have an impact on the value of the financial instrument.
5. Credit Risk
Credit risk is the inability of the borrower or the issuer to pay the interest. The credit rating agencies rate the asset based on certain criteria. High rated bonds have low credit risk. At the same time, low rate bonds have high credit risk. In other words, a credit rating implies the ability of the borrowers or issuer to pay interest and principal. A high rating implies low chances of default and vice versa.
6. Inflation Risk
Inflation reduced the purchasing power. Rising inflation is a risk that one should keep in mind while investing in any asset. You should always invest in schemes that generate inflation-beating returns. If your investments are not generating higher returns than the prevailing interest rate, then you are just losing money from your investment. Holding idle cash is the best example of money-losing value with time. For example, if your investment is generating a 7% return and the inflation is around 6%, your actual return from your investment is only 1%.
Currency risk refers to fluctuations in the exchange rate. A decrease in the exchange rate will reduce investment returns. For example, when the value of a foreign currency-denominated fund rises, the value of the investment during redemption is lower. In other words, when converted into INR, it results in a lower rate of return.
7. Rebalancing Risk
The fund managers rebalance and review mutual fund investments on a regular basis. On the other hand, regular reinvestments come with the danger of missing out on investment growth possibilities. Frequent rebalancing will also increase the costs associated with the fund’s management.
Mutual fund investments are exposed to management risk. Management risk is the possibility that the fund manager of the fund will underperform the benchmark. Investing in index funds is one approach to eliminate management risk. However, the index fund will never outperform the market in terms of returns.
8. Regulatory Risk
As the name suggests, regulatory risk is a type of risk that depends on the announcements and regulations by the Government. Any law or regulation that may hurt a sector that you have invested in will affect the value of your investment. For example, if the Government passes legislation restricting the production and use of non-renewable energy such as thermal energy, your investments in coal and thermal power-related funds may be negatively impacted.
Risk Mitigation Techniques
Risk is inevitable. However, how you combat the risk is what matters. Mutual fund investments are risky. However, they have the potential to generate significant growth. An investment plan executed with care will fulfil your aims. The following techniques will help you mitigate risks associated with mutual fund investments:
1. Create a well-diversified portfolio
Picking the right funds that match your risk tolerance levels is very important. At the same time, it is essential for you to create an investment portfolio that isn’t concentrated across one asset class or theme or sector. It is a good strategy to have an optimum balance between the asset classes in your investment portfolio. Analyse your goals, investment horizon, and risk tolerance levels and pick funds that will perform even during a market turmoil.
2. Systematic Investment Plan (SIP)
Investing through SIP will help you average out market volatility. To elaborate, the NAV of a mutual fund is INR 100, and you invest INR 10,000 (100 units). Next month, the NAV of the fund reaches 110, and for the SIP amount of INR 10,000, you will only set 90.91 units. In the following month, the NAV falls to INR 80, and you will now get 125 units for the SIP amount. Therefore, through SIP investing, you will accumulate more units when the NAV falls and benefit from price appreciation when the NAV increases. Ultimately, you are able to average out the price fluctuations through regular investing. With SIP, you will benefit from rupee cost averaging and the power of compounding.
3. Systematic Transfer Plan (STP)
Investing through STP also helps to spread the risk of mutual fund investments across time while also lowering the average cost of investment. It helps to mitigate the effects of entering an inflated market. The ability for you to switch from one fund to another aids in the successful consolidation of gains and reduces the associated risks.