What does ‘Mutual Fund is subjected to market risk’ really mean?

‘Mutual Fund Sahi Hai’ campaign has been very successful in attracting people to buy Mutual Funds. However, it can mislead people into thinking that it is safe, that there are actually no risks in Mutual Funds. It has the power to lull people into ignoring the statutory warning, ‘Mutual Funds are subjected to market risk….’, Just like cigarette smokers ignore the warning which is so much more threatening and conclusive, ‘Smoking Kills!’

While it’s true that Mutual Funds in India can be a good investment option, you shouldn’t forget that they have an inherent market risks associated with them. Risks are inevitable in stock investing, because we are dealing with future, and the future is uncertain. Understanding risks helps you take actions to control and manage them. And, then you expect returns that do justice to the risks you have taken.

What are the risks in Equity Mutual Funds?

1. Volatility Risk:

Volatility means that it can change rapidly and unpredictably e.g. stock prices. As Equity Mutual Funds are invested in portfolio of stocks, their NAV-value/prices are also volatile. Despite knowing this, different investors react to volatility differently, and that is what causes a bigger damage. It has been found in a study that, an average Mutual Fund investor doesn’t hold an MF beyond 24 months. Investors with lower risk appetite, as MF investors tend to be, sell when the value of his investment goes down. This leads to permanent loss of capital or not enjoying the full benefit of having invested in right assets.

Staying invested in the market for a longer period is the best solution to fighting volatility risks. And, ensuring your portfolio does not have a significant Downside at any point of time significantly increases the chances of you staying invested.  A portfolio of Equity and Debt Funds has lower volatility. Also, Smart Asset Allocation - moving the ratio in favour of Debt, when the markets rise irrationally, also reduces the downside risk.

SIP in MFs has proven to be a popular solution to prevent investors from reacting counter-productively to volatility. It predisposes the investor to invest, and therefore, to hold his/her earlier investments in a Mutual Fund through ups and downs. In all these, it is critical that you invest in the right Mutual Funds, because time won’t reduce all risks e.g. Fund Manager Risks.

2. Fund Manager Risk:

Not many Mutual Funds in the past have consistently performed, irrespective of the market scenario. There’s always a risk that a Fund Manager may underperform during some years, as all the investment strategies (Value Investing, Growth Investing etc.) don’t work for all times. How a Fund Manager reacts to periods of under-performance is more important. The risks are higher, when a Fund Manager does not stick to process-driven investing. It may happen due to the pressure to generate returns more than Benchmark Index in the short run…perhaps also intensified by his incentives and career aspirations. This approach clashes with the investors’ goal i.e. ‘to generate wealth in a sustainable manner over long run.’ This misalignment can be eliminated only by exiting a Fund. The other source of risk here is the exit of a performing Fund Manager. The lack of track record of the new Fund Manager adds to the uncertainty and risks

3. Concentration Risk:

If a Mutual Fund invests a large portion of its portfolio in select sectors or stocks of particular size like Small Caps, there’s a high risk that the Fund will not perform, if that pocket of the market doesn’t do well. Hence, it’s wise to either diversify or avoid Thematic Funds like Sectoral Funds or Small Cap Funds altogether. One may choose to invest only in diversified Multi-Cap Funds to reduce risk of concentration.

4. Liquidity Risk:

This is the risk of prices falling, when a Fund tries to sell, usually a ‘largish’ amount a stock. The prices quoted in the exchange are the result of a dynamic equilibrium between the demand and supply of every stock at a price. Liquidity Risk occurs when the prices fall, because the quantity available for sale is large compared to the average volume traded. This means that a Fund Manager won’t be reduce/exit a stock at the currently quoted prices.

Funds need to be ready at all times to process redemption requests as they come in. They should have either cash-on-hand or securities readily convertible to cash. Popular Funds have a huge AUM, and thus, hold a large amount of specific stocks at any given time. They are exposed to Liquidity Risk due to the large holding. In many cases, Funds can hold risky or thinly traded securities that pose a threat to a Fund’s ability to raise cash without incurring a heavy cost.

What are key risks in Debt Mutual Funds?

Most investors believe that Debt Mutual Funds are safe, since they give fixed returns. However, Debt Funds too can be risky, even if the risk may not be as high as in Equity Mutual Funds. Though Government securities are safe as they can print currency to honour interest payments, Corporates may go bust.

1. Credit Risk:

Debt Mutual Funds invest in Debt instruments issued by the Government or Corporates. A Credit Risk is the risk of default on a debt that may arise from a borrower failing to make required payments. This leads to permanent loss of capital. It’s important to choose a Debt Fund that invests in BBB+ and above rated securities.

2. Interest Rate Risk:

While the Government Debt does not have the credit risk, they do have the duration risk. You are exposed to this risk, as during the period you hold these assets, the interest rates may rise or decline. If the interest rates rise, Bond prices come down leading to fall in investment value in a short term. If you sell the Bond you will incur a real loss. However, if you hold it till maturity, you would get the expected returns.

You need to avoid the common errors that lead to losing capital in markets by answering few important questions:

• Do I have a long enough time horizon required for equity investing?
• Does the Mutual Fund I choose suit my risk profile?
• Do I understand what I am buying or am I blindly investing in a Fund on the insistence of my friends, acquaintances or Mutual Fund Distributors (who earn commissions on what they sell to me)?
• Am I chasing higher returns and exposing myself to higher risks than what I can handle. Is my exposure to Mid and Small-Cap Funds very high?
• Am I over-exposed to one Fund or one type of Funds? Do I know if I have a good combination of Funds?

Ask questions and learn more about investing in Mutual Funds because ignorance is the biggest risk. And, you probably have a few decades of investing to do, so investing your time in learning about investing is the best investment you can make!