In the previous article, we discussed taxation in mutual funds. In this article, we will discuss the types of risks associated with mutual funds.
Mutual funds are excellent investment options for both novice and seasoned investors; they are currently a very popular investment option due to their capacity to provide inflation-beating returns.
Mutual funds combine money from a range of individuals and institutions and invest in various asset classes such as shares, debt, and other money market instruments after conducting thorough research to maximize capital appreciation or income generation.
The investors are subject to risks like volatility risk, management risk, liquidity risk, interest rate risk, and inflation risk. We shall now discuss all such risks that come up with an investment in mutual fund schemes; a sound knowledge of these is helpful to an investor in making the investments.
There are two types of mutual funds: equity mutual funds and debt mutual funds.
Risks associated with mutual funds
There are major two types of risks associated with mutual funds that the article will discuss such as risks associated with equity mutual funds and risks associated with debt funds.
1. Management risk
A company’s management refers to the group steering the organization on the right path.
Changes in the management team and their activities, such as pledging shares, decreasing or increasing promoter stakes, and so on, can impact the price of a company’s stock.
While principles such as solid corporate governance and high transparency benefit a company’s stock, mismanagement, team conflicts, and other factors depress the stock price and thereby affect your mutual fund investments as well if that particular stock is a part of your investment.
2. Liquidity risk
When it comes to equity investments, long-term investing has the best possibility of securing investment profitability.
Thus, it is difficult for equity mutual funds to quickly buy or sell stock investments to profit or minimize a loss leading to a situation where the scheme’s liquidity is insufficient to meet investors’ redemption requests.
A liquidity crisis like this is most prevalent when investors make a high number of redemption requests due to prolonged bad market inequities.
Many equity funds invest a small amount of their capital in debt and money market instruments to mitigate this risk and ensure more substantial returns.
3. Volatility risk
An equity mutual fund invests mainly in the stocks of publicly traded corporations.
As a result, an equity fund’s value is in line with the performance of the companies in whose stocks it has invested. Current macroeconomic conditions have an impact on the company’s performance.
Government, Sebi, and RBI policies, consumer preferences, the economic cycle, and other macroeconomic changes are all examples of factors that directly impact the price of company stock, either positively or negatively.
The value of an equity fund is affected by this movement. Large-cap corporations, on average, are less prone to such volatility than mid-cap and small-cap market enterprises.
Similarly, when compared to thematic or sectoral equity, funds are diversified. Equity funds are less likely to be influenced by such volatility.
Risks associated with debt funds
1. Inflation risk
Bonds and money market instruments are fixed-rate instruments because their coupon rates are fixed. As a result, rising inflation erodes the coupon rate-based revenues that the debt fund aims to receive.
As a result, rising inflation causes bonds to trade at a lower price on the bond markets, lowering their potential returns for the debt funds investors.
On the other hand, lower inflation tends to push bond prices and debt fund investment values higher.
2. Credit risk
Government securities, corporate bonds, certificates of deposits, commercial papers and other debt and money market instruments are among the items that debt funds invest in.
Credit ratings such as AAA, AA+, AA, AA- and so on are offered by credit rating agencies such as CRISIL, ICRA, and Fitch they evaluate the credit quality of these investments, which vary depending upon the issuer.
A specific risk is that the borrower fails; they do not pay the principal and/or interest on the loan.
3. Interest rate risk
A risk linked with debt funds is interest rate risk. Bonds are exchanged in the same way as stocks, and their prices fluctuate.
The economies’ interest rates mainly influence the movement in bond prices; the link between interest rates and bond prices is the opposite. As a result, as the economies’ interest rate rises, the values of current bonds fall since they continue to offer the same interest rate.
Interest rate risk refers to price variation in bonds caused by changes in interest rates it is a market-wide element that influences bond prices and, as a result, the value of all debt mutual funds.
The degree of interest rate sensitivity varies by debt fund type and is shown by the adjusted duration of the debt fund.
In general, debt funds that invest in shorter-term assets are less vulnerable to interest rate risk than those that invest in longer-term products.
With regard to the above-mentioned risks, it is vital to note that while mutual fund performance is always subject to numerous risks, every fund house employs a variety of tactics to reduce, if not eliminate, these well-known dangers.
As a result, even if your investment gains are not guaranteed, your chances of developing your wealth are good if you invest with a well-known fund house, choose a fund with an established track record, and make the investment with a long-term horizon.
FAQs
What are the three main risks associated with mutual funds?
The three main risks associated with mutual funds are:
- Management risk
- Liquidity risk
- Volatility risk
Do mutual funds have high risk?
All mutual funds are risky. Its terms and conditions specify that mutual funds are volatile in nature and are subject to market ups and downs. There are different levels of risk involved in mutual funds.
What is the biggest risk for mutual funds?
The biggest risk for mutual funds is inflation. Inflation affects different types of funds differently.
Rising inflation causes bonds to trade at a lower price on the bond markets, lowering their potential returns for debt fund investors. On the other hand, lower inflation tends to push bond prices and debt fund investment values higher.
