When we talk about mutual funds, we typically hear the advantages associated with investing in a mutual fund. They provide stable returns, they’re lose prone to volatility and fluctuations in value. They’re generally a safer bet compared to say, direct investments in the equity markets, since they’re a more diversified investment. Plus of course, they help investors avoid the effort and stress involved in making investments themselves, since fund managers take informed, educated decisions about fund allocations for the investors.
But, if you are not cautious, even mutual fund investments can adversely impact your wealth. If you’re investing in a mutual fund, it is crucial to do your research, take the necessary precautions, and have some idea of what you’re getting into. Here’s a roundup of all the possible risks associated with mutual funds.
- Market risk: Mutual fund advertisements are a common sight, whether they’re on television networks or print and digital media. These advertisements are always accompanied by some fine print – “Mutual fund investments are subject to market risks. Please read the offer document carefully before investing”. While mutual fund companies are legally mandated to put in this disclaimed, this is also well-intentioned advice. Mutual funds which invest in the equity markets are affected by market volatility.
As an investor, you should avoid investing in aggressive mutual fund schemes when the markets are volatile. Instead opt for other mutual fund options that are invested in stocks with more stable movements. If you’ve incurred a loss due to the volatility in the market, analyse your position and decide on whether you’ll wait for the situation to get better or cut your losses. Having said that, mutual funds typically remain a safer bet compared to assets like stocks even in volatile markets.
Of course, market risk is not common to all the mutual funds available in the market. Not all mutual funds invest in the equity markets. Debt funds for example, will be subjected to other sorts of risk that we’ll discuss below. However, many investors are generally unaware of this fact and consider mutual funds risky as a whole.
- Concentration risk: When you invest a chunk of your funds in a single mutual fund (or on funds investing in similar industries), your investment is concentrated in one scheme or sector. This may not end well for you. Like stock market investments, you should also diversify your mutual fund investments across multiple schemes and sectors. For example, offerings from the SBI Mutual Fund include multiple kinds of mutual fund schemes which allow investors to channel their funds across different sectors and securities. The more you diversify your mutual fund portfolio, the lower risk you are exposed to.
- Interest rate risk: When you invest in a debt fund, the interest rates they are going to earn from fluctuate with bond prices. The gains on of your debt fund investments are inversely related to bond prices. So, with the rise and fall of the interest rate, the Net Asset Value of your debt fund will increase or decrease. So you must be cognizant about the current market sentiment, the status of the economy, and stay updated on bond prices.
- Credit risk: When you invest in a debt fund, there is a risk, however small, that the bond issuer of the scheme may not be able to pay the interest it promises. Rating agencies rate these issuers on their ability to repay with interest. A firm which has a high rating pays less interest and vice-versa. These risks are typically associated with debt funds when they include low credit-rated securities in their portfolio to earn a higher return. It is advisable that you always have a look at the credit-rating of the securities included in the portfolio of your fund of choice, before you make your investment.
- Liquidity risk: The lock-in period in some mutual funds certainly possesses liquidity risk. As an investor, you cannot do much if your fund is in lock-in period and it exhibits unfavorable moments. Exchange Traded Funds (ETFs) also suffer from liquidity risk, as ETFs are traded in the stock market like shares. When there is a lack of buyers for your ETF, you will be unable to redeem your investment. The ideal way around this is to diversify your mutual fund portfolio and select your funds diligently.
- Macroeconomic risk: Mutual funds are also affected by macroeconomic risks – such as growth, corporate earnings, inflation, interest rates, etc. These factors indirectly affect the NAV of mutual funds. When the economy of a country is growing, mutual fund schemes will also grow, and when the economy is in a tumultuous state, mutual fund schemes may lose their value. Again, mutual funds are more resistant to such risks than many other asset classes out there.
- Exchange rate risk: These risks are associated with the mutual fund schemes invested in companies such as import-export companies, software companies that get a bulk of their business from overseas, MNCs or companies that need imported raw material for running its business. These companies are affected by the fluctuations in the value of foreign currencies.
Though mutual fund possesses many risks, with a more broad perspective and research, you can mitigate these risks. As long as your selection of mutual fund involves diversification across schemes and sectors, a proven track record and a reputed fund house, you are most likely to get good returns if you are invested for the long-term.