Why are Mutual Funds Subject to Market Risk?

7 Mins

All the mutual fund schemes have a disclaimer ‘Mutual funds are subject to market risk. Read all scheme-related documents carefully.’ Like other investment instruments, mutual funds are also subjected to market risk. This is because there is no way to predict the future or how particular security may perform. Also, markets cannot be accurately predicted or controlled, as it depends on numerous factors. Thus, no investment is risk-free in the market.

What is Market Risk in Mutual Funds?

Market risk is the risk that exists in all types of investment instruments. This is due to the volatile nature of the market and the global economy in general. In simple words, the possibility of the market or economy to decline or rise affects individual investments to lose or gain value regardless of the performance of the issuing entity. For instance, in the stock market crash of 2008 where every company stock lost its value despite not having done anything wrong or changed its operations. Thus, companies cannot prevent or predict such situations.

A mutual fund portfolio comprises different financial securities like equity, debt, bonds, government securities, etc. Similarly, market risk in mutual funds means every underlying security is exposed to different risks. For instance, equities are exposed to market risk, liquidity risk, etc. Similarly, debt is exposed to interest rate risk, credit risk, etc. As per SEBI regulation, every mutual scheme has a certain level of risk associated with it which is defined over a risk-o-meter.

Mutual Funds are Subject to Market Risk

A mutual fund holds a portfolio of investments that are affected by market and economic factors. This, in turn, affects the performance of the mutual fund. Here are the types of market risks that affect mutual funds –

Macroeconomic Risk

The Marco economic risk refers to social, political and legislative risks. Any changes in government policies, regulations, tax regimes, and social or national changes can impact the value of all asset classes.

Interest Rate

The interest rate changes from time to time and shows which direction the economy is heading. The value of fixed-income securities is inversely related to interest rates. Usually, when the interest rate rises, the price of these securities fall and vice versa. Consequently, the value of a mutual fund portfolio will also fall when the interest rates increase. Also, the extent of a fall or rise in prices depends on the coupon and maturity of the security.

Inflation

Inflation risk means losing purchasing power due to rising prices of goods and services. This can affect the company’s profitability due to rising prices and affect the mutual fund NAV. Furthermore, investors always want to earn returns more than the inflation rate. For instance, if a mutual fund earns 7% per annum and the cost of living is 3%. The net returns that an investor earns is 4%. This is known as the real rate of return.

Exchange Rate

Foreign exchange rate risk refers to the risk that businesses or governments face during operations or financial transactions with other countries by changes in the exchange rate between currencies. When the currencies fluctuate, it also affects the overall market economy. For instance, if the currency is depreciating it has an impact on different market segments. Also, the stock market is sensitive to these fluctuations and impacts investors’ sentiments. Therefore, while investing in international mutual funds the fund managers have to consider the exchange rate risk while buying and selling in the overseas market.

Commodity Risk

Any changes in commodity prices will change in a way that may cause economic losses. This is the real risk to businesses or consumers as everything from raw materials to finished products depends on buying and processing commodities. As a result, any changes in commodities can impact the price of gas at filling stations to that of groceries or goods. For instance, the rise in crude oil prices will have an adverse impact on the Indian economy because India imports crude oil.

Global Risk

Any changes in the foreign country can impact other countries markets. For instance, if the Fed has increased interest rates in the US, this has an impact on the Indian market as well. Thus, foreign countries’ statutory changes or economic instability can affect our domestic markets as well.

How to Deal with Market Risk?

Even though risk exists in mutual fund investments, they have the potential to generate significant growth for investors. One cannot measure market risk or avoid it. But there are ways to deal with market risk. The following are some techniques to deal with market risk:

Build a portfolio that matches the investment goal

The simple way to minimise market risk in mutual funds is to invest in funds that match the investor’s financial goals based on the risk tolerance levels. Therefore, factors such as age, risk profile, time horizon, and financial objectives must be considered while selecting a mutual fund scheme. For instance, investors with low-risk tolerance and long-term financial goals can build a well-balanced portfolio combining equity and debt.

SIP investment

Systematic Investment Plans (SIP) are one of the best ways to mitigate the market risk in mutual funds. Investing small amounts regularly in a disciplined manner for a long duration can help generate significant growth. Irrespective of the market situation, SIP can provide the benefit of rupee cost averaging and the power of compounding to grow money over the years.

Explore: What is Rupee Cost Averaging?

Diversification of portfolio

Diversification of portfolio means allocating investments across different asset classes and sectors like debt, equity, commodity, etc. This helps to balance the portfolio’s risk-reward ratio and manage the market risks effectively. Investors can diversify their portfolio based on their investment horizon, risk profile and investment objectives. For instance, investors can invest in debt funds for stable returns rather than equities while planning for short-term goals. Alternatively, investing in equity funds for long-term goals is efficient as it has a high risk-reward factor.

Frequently Asked Questions

Are mutual funds risk-free?

Mutual funds are subjected to market risk is the most common disclaimer. Thus, no mutual funds can guarantee returns as they have a certain element of risk associated with it. Investors looking for risk-free returns can prefer government-backed instruments.

Are all mutual funds subject to market risk?

Yes, all mutual funds are subject to market risk. The degree of risk may vary depending on the type of mutual fund. Because of market risk, the mutual fund NAV may rise or fall depending on the market forces affecting the securities.

Should you invest in mutual funds when the market is high?

There is no best time to invest in mutual funds. You should invest in mutual funds now. This means you can invest in mutual funds anytime as you need not worry about managing your investments and invest the desired amount regularly. Also, staying invested can help you average out the market volatility.

Do mutual funds guarantee returns?

Because mutual funds are subject to market risk, they do not guarantee returns or capital protection. The purpose of investing in mutual funds is to earn significant growth than what traditional investment options can provide.