Types Of Risks Associated With Mutual Funds

Are Mutual Funds risky? Well, all instruments come with some risks. Mutual funds come with a lower risk than many other instruments. The upside to the risk in mutual funds is that you can earn substantial returns, which are significantly higher than in fixed-returns instruments. 

Moreover, there are ways to reduce risks associated with these instruments through diversification. You can cherry-pick a variety of mutual funds, of which some are debt-linked and equity-linked, while others are hybrid. 

Regardless of what you pick, there is some level of risk involved in this instrument, but then, no investment promising high returns is risk-free.  

Why is Mutual Fund Investment Risky?

The risk in mutual funds arises from the fact that it is entirely market dependent. Through mutual funds, you invest your corpus in debt, equity, corporate bonds, etc., which fluctuate in value. Where at times, you'll earn solid returns, you may also experience a slump.

The value fluctuation is a direct result of changes in the NAV or Net Asset Value of the fund. NAV is the current per-unit market value of schemes you have invested in.

You can mitigate mutual funds risk by studying them beforehand.  

Types of Risks Associated with Mutual Funds

Want to invest in mutual funds? If yes, here are the types of mutual fund risks you must familiarise yourself with before investing. 

Market Risk

How many times have you come across this ad slogan? “Mutual funds are subject to market risk. Please read all scheme-related documents carefully before investing”.

The term “market risk” simply means any losses an investor may incur due to the overall poor performance of the market. You must have heard mutual fund investors discussing how the market is down today or has been down for one week. When such a thing happens, your NAV goes down. As a result, you earn a low percentage of returns. 

In such a scenario, it is often advised to stay invested in the market, as it will eventually normalise or show an upward trend. When it does, your NAV shoots up, and you start earning high returns.

Market mutual fund risk is also called systematic risk. Here, portfolio diversification doesn’t help as much as staying invested in the market.

Concentration Risk

This mutual fund risk arises when an investor moves away from portfolio diversification by focusing on one or two schemes alone. Parking most of your corpus in one mutual fund scheme is considered risky. While you can book colossal profits if that one scheme performs well, the losses will also be pronounced if it doesn't.

Mutual fund experts or seasoned investors may take this approach after thorough research or when they strongly expect a particular scheme to do well. However, beginner investors should stick to portfolio diversification to mitigate concentration mutual fund risk.  

Liquidity Risk

Picture a scenario where you urgently need to offload your mutual funds but are unable to find buyers in the market or have a lock-in period. The inability to redeem an investment without incurring losses poses a liquidity risk.

For instance, suppose you have invested a chunk of your corpus in Equity Linked Mutual Funds or ELSS that often come with a lock-in period. Prematurely liquidating these funds can cause a penalty, or you simply cannot dissolve them. The precise liquidation terms are customised and mentioned in the scheme-related document.

A similar example is that of Equity-traded funds or ETFs, which are traded on the stock market like shares. An investor may find it difficult to offload certain ETFs due to buyer unavailability, which can pose a risk in mutual funds. 

A possible workaround is portfolio diversification and conducting thorough research to select the right mutual funds. Because both ELSS and ETFs can offer excellent returns. 

Interest Rate Risk

Another risk in mutual funds is the fluctuation of interest rate. An increase in interest rates will lead to a fall in bond prices and vice versa. So, any change in interest rates can fluctuate the value of the linked instrument. Simply put, bond prices and interest rates are inversely proportional.

To counter this risk, you must study the historical performance of the mutual fund schemes you plan to invest in. Also, portfolio diversification helps in this case. 

Credit Risk

The credit risk in mutual funds arises when the scheme’s issuer fails to pay the promised interest. To ensure this doesn’t happen, rating agencies carefully rate fund houses and AMCs that offer schemes to investors. You will often notice that a top-rated agency or AMC will promise lower interest rates as opposed to a low-rated one. 

The credit risk factors of mutual funds also extend to debt-linked schemes when the fund manager ends up including low-rated securities. They do this to earn higher returns. Usually, fund managers only incorporate investment-grade securities in debt funds. 

Low credit rating of schemes in your portfolio can earn you high returns, but they also put you at credit risk. Therefore, before investing, study the credit ratings of schemes you want to include in your financial portfolio. 

Inflation Risk

The risk factors of mutual funds also include inflation risk. But this doesn't solely depend on the performance of mutual funds. You can anticipate this risk due to a high inflation rate. For example, if the inflation rate is 3% and your mutual fund returns stand at 5%, your actual returns are only 2%.

Investors are exposed to the inflation mutual fund risk factor when their scheme stops earning high returns. It’s not that the scheme is not earning positive returns, but how those returns are offset by high inflation rates. 

To keep inflation risk at bay, invest in mutual funds with a strong performance history. Here, too, portfolio diversification helps, as underperforming schemes are balanced out by funds earning high returns. 

Conclusion

In addition to mutual funds, you can also invest in Systematic Investment Plans or SIPs. These instruments invest in mutual funds, but the investor doesn’t require a lump sum to start a SIP. They can invest in this instrument with as little as Rs. 500. Doing this substantially reduces risks in SIP and earns significant returns in the long run.

Want to invest in mutual funds and SIPs? Do it through one of India’s trusted portals Tata Capital Moneyfy. Get started by creating your account with us, comparing different fund schemes & investing in them instantly. You can also download the Moneyfy app to invest on the go.
For more details, visit the Moneyfy website.