Risks Associated with Mutual Fund Investing: Types and Mitigation Strategies
Posted on 17-May-2024
6 min read
Mutual fund investments come with inherent risks. But there are always ways to identify and mitigate those risks confidently. Read this guide by Shriram AMC for more information.
Table of Content
If anyone promised you high or guaranteed returns on your investments without the slightest exposure to risks, it’s your cue that this doesn’t look good! There cannot be any kind of investment that does not come with risks. In fact, it is these risks that promise a high or at least a fair share of returns.
It is almost never possible to eliminate risks, and that holds true for every aspect of our lives as well. Before we derail from the topic at hand and get all philosophical about life and its inherent meaning, let’s quickly get back to discussing mutual funds and their inherent risks.
A fair share of knowledge and awareness about mutual fund risks can help you handle and mitigate the same seamlessly. Let us now see how!
“Mutual fund investments are subject to market risks. Please read the offer document carefully before investing.”
Well, looks like our life has come to a full circle!
Investing in mutual funds is risky due to the inherent market risks they come with. Market risks refer to the possibility of the overall market declining, leading to a decrease in the fund's Net Asset Value (NAV).
There are several reasons why there could be a gradual or a sudden dip in the NAV. But what investors need to understand is that those reasons have a direct impact on the price movement of financial instruments like equities, bonds, debt, government securities, etc., that mutual funds invest in.
The market is volatile and will always be. Therefore, no one, not even the best fund manager on the planet, can vouch for the quality of your returns and determine precisely how much risk you are taking by investing in specific fund(s).
Yes, some funds are comparatively less risky than others. And a fund manager helps you choose funds based on your financial goals, investment style and risk appetite.
• Concentration Risk: This risk arises when a fund invests heavily in a particular sector, asset class, or a small number of companies. If that specific area underperforms, the fund's value can suffer disproportionately.
• Interest Rate Risk: This risk is relevant for debt funds. When interest rates rise, the value of existing bonds held by the fund can decrease.
• Liquidity Risk: Some mutual funds, especially closed-end funds or those investing in illiquid assets, may have lower liquidity. This means it might be difficult to sell your shares quickly without incurring a loss.
• Credit Risk: Debt funds are susceptible to credit risk, which is the risk of the issuer of a bond defaulting on their debt obligation. This can lead to a loss of principal for the fund.
• Expense Ratio: The ongoing fees associated with managing the fund can eat into your returns. Higher expense ratios can impact your overall profitability.
• Manager Risk: The performance of the fund is heavily dependent on the skill and investment decisions of the fund manager. Choosing a fund with a consistent track record can help mitigate this risk.
• Sectoral Risk: Funds focused on a specific sector are vulnerable to downturns in that sector.
• Company-Specific Risk: The performance of a single company within the fund can significantly impact its overall value.
• Duration Risk: Longer-duration bonds are more sensitive to interest rate fluctuations.
• Diversification: Invest in a variety of mutual funds across different asset classes and sectors to spread out your risk. For instance, you can add Shriram Flexi Cap Fund and Shriram Balanced Advantage Fund to your portfolio to balance the risk of equity funds with hybrid funds.
• Investment Horizon: Match your investment horizon to the risk profile of the fund. Equity funds are suitable for long-term goals, while debt funds can be used for shorter-term needs.
• Risk Tolerance: Choose funds that align with your risk tolerance. Aggressive investors can handle higher equity allocation, while conservative investors may prefer debt funds.
• Invest Via SIP: A Systematic Investment Plan (SIP) might be a great option for risk-averse investors or anyone looking to start small. It allows you to invest small amounts each month, even as little as Rs. 500, offering you peace of mind and enough time to become aware of the market.
• Optimum Research: Understand the investment objective, expense ratio, and portfolio holdings of the fund before investing.
Happy investing!
1. Is there a risk-free mutual fund option?
Unfortunately, there's no such thing as a completely risk-free mutual fund. Even money market funds, considered the least volatile, carry minimal credit risk. However, diversification across asset classes and choosing low-cost index funds can significantly reduce overall risk.
2. How can I measure the risk of a mutual fund?
Several metrics can help you gauge a mutual fund's risk profile. Standard Deviation measures the fund's historical volatility, and the Sharpe Ratio evaluates its risk-adjusted return. Additionally, studying the fund's beta (a measure of its volatility compared to the market), and its maximum drawdown (largest peak-to-trough decline) can be insightful.
3. Should I avoid actively managed funds due to manager risk?
Actively managed funds aim to outperform the market, but this introduces manager risk. However, not all actively managed funds are risky. Consider funds with a long track record of outperformance and a clear investment philosophy that aligns with your goals.
4. Are there tax implications for mutual fund risks?
Capital gains taxes apply when you sell mutual fund shares at a profit. Understanding the fund's turnover rate (how often it buys and sells securities) can help estimate potential capital gains taxes. Funds with lower turnover rates tend to be more tax efficient.
5. What if I need to access my money before the investment horizon?
If you might need your money before the recommended investment horizon for the fund (especially for equity funds), consider a staggered investment approach or choose funds with higher liquidity. However, remember that early redemption might result in capital gains taxes or even a loss if the market is down.
It is almost never possible to eliminate risks, and that holds true for every aspect of our lives as well. Before we derail from the topic at hand and get all philosophical about life and its inherent meaning, let’s quickly get back to discussing mutual funds and their inherent risks.
A fair share of knowledge and awareness about mutual fund risks can help you handle and mitigate the same seamlessly. Let us now see how!
What Makes Mutual Fund Investment Risky?
Remember that advertisement about mutual funds that would appear every five minutes on your television, ruining your entertainment? One where the person would speak like his life depended on it and we were too naive to understand what that meant? Let’s jog your memory, because that is what we are going to discuss in this section—“Mutual fund investments are subject to market risks. Please read the offer document carefully before investing.”
Well, looks like our life has come to a full circle!
Investing in mutual funds is risky due to the inherent market risks they come with. Market risks refer to the possibility of the overall market declining, leading to a decrease in the fund's Net Asset Value (NAV).
There are several reasons why there could be a gradual or a sudden dip in the NAV. But what investors need to understand is that those reasons have a direct impact on the price movement of financial instruments like equities, bonds, debt, government securities, etc., that mutual funds invest in.
The market is volatile and will always be. Therefore, no one, not even the best fund manager on the planet, can vouch for the quality of your returns and determine precisely how much risk you are taking by investing in specific fund(s).
Yes, some funds are comparatively less risky than others. And a fund manager helps you choose funds based on your financial goals, investment style and risk appetite.
Types of Mutual Fund Risks
Beyond market risk, several other risk factors can impact your mutual fund investment. Let’s learn about them in this section:• Concentration Risk: This risk arises when a fund invests heavily in a particular sector, asset class, or a small number of companies. If that specific area underperforms, the fund's value can suffer disproportionately.
• Interest Rate Risk: This risk is relevant for debt funds. When interest rates rise, the value of existing bonds held by the fund can decrease.
• Liquidity Risk: Some mutual funds, especially closed-end funds or those investing in illiquid assets, may have lower liquidity. This means it might be difficult to sell your shares quickly without incurring a loss.
• Credit Risk: Debt funds are susceptible to credit risk, which is the risk of the issuer of a bond defaulting on their debt obligation. This can lead to a loss of principal for the fund.
• Expense Ratio: The ongoing fees associated with managing the fund can eat into your returns. Higher expense ratios can impact your overall profitability.
• Manager Risk: The performance of the fund is heavily dependent on the skill and investment decisions of the fund manager. Choosing a fund with a consistent track record can help mitigate this risk.
Risks Involved with Equity Mutual Funds
Equity funds invest in stocks, which are inherently more volatile than debt instruments. Here are some additional risks specific to equity funds:• Sectoral Risk: Funds focused on a specific sector are vulnerable to downturns in that sector.
• Company-Specific Risk: The performance of a single company within the fund can significantly impact its overall value.
Risks Involved with Debt Mutual Funds
Debt funds, although generally considered less risky than equity funds, also have risks, and one very specific one:• Duration Risk: Longer-duration bonds are more sensitive to interest rate fluctuations.
Mitigating Mutual Fund Risks
As mentioned earlier, you cannot completely avoid risks while investing in mutual funds. But you can certainly minimize the risk and increase the chances of potentially high returns. Here are some ways to do so:• Diversification: Invest in a variety of mutual funds across different asset classes and sectors to spread out your risk. For instance, you can add Shriram Flexi Cap Fund and Shriram Balanced Advantage Fund to your portfolio to balance the risk of equity funds with hybrid funds.
• Investment Horizon: Match your investment horizon to the risk profile of the fund. Equity funds are suitable for long-term goals, while debt funds can be used for shorter-term needs.
• Risk Tolerance: Choose funds that align with your risk tolerance. Aggressive investors can handle higher equity allocation, while conservative investors may prefer debt funds.
• Invest Via SIP: A Systematic Investment Plan (SIP) might be a great option for risk-averse investors or anyone looking to start small. It allows you to invest small amounts each month, even as little as Rs. 500, offering you peace of mind and enough time to become aware of the market.
• Optimum Research: Understand the investment objective, expense ratio, and portfolio holdings of the fund before investing.
Final Words
Mutual funds offer a convenient and accessible way to invest, but it's crucial to be aware of the potential risks involved. By educating yourself about these risks and tailoring your investment strategy to your risk tolerance and financial goals, you can harness the power of mutual funds to achieve your long-term financial objectives. Remember, knowledge is power – use it to make informed investment decisions and build a secure financial future. Finally, trust Shriram AMC to help you with all the information you need to start investing and minimize your exposure to market risks.Happy investing!
FAQs
Here are some of the commonly asked questions about risks associated with mutual funds:1. Is there a risk-free mutual fund option?
Unfortunately, there's no such thing as a completely risk-free mutual fund. Even money market funds, considered the least volatile, carry minimal credit risk. However, diversification across asset classes and choosing low-cost index funds can significantly reduce overall risk.
2. How can I measure the risk of a mutual fund?
Several metrics can help you gauge a mutual fund's risk profile. Standard Deviation measures the fund's historical volatility, and the Sharpe Ratio evaluates its risk-adjusted return. Additionally, studying the fund's beta (a measure of its volatility compared to the market), and its maximum drawdown (largest peak-to-trough decline) can be insightful.
3. Should I avoid actively managed funds due to manager risk?
Actively managed funds aim to outperform the market, but this introduces manager risk. However, not all actively managed funds are risky. Consider funds with a long track record of outperformance and a clear investment philosophy that aligns with your goals.
4. Are there tax implications for mutual fund risks?
Capital gains taxes apply when you sell mutual fund shares at a profit. Understanding the fund's turnover rate (how often it buys and sells securities) can help estimate potential capital gains taxes. Funds with lower turnover rates tend to be more tax efficient.
5. What if I need to access my money before the investment horizon?
If you might need your money before the recommended investment horizon for the fund (especially for equity funds), consider a staggered investment approach or choose funds with higher liquidity. However, remember that early redemption might result in capital gains taxes or even a loss if the market is down.
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