Risks Associated with Investments in Mutual Funds explained

Mutual Fund Schemes are not guaranteed or assured return products. Remember, past performance does not guarantee the future performance of any Mutual Fund Scheme. Different mutual fund categories are exposed to different kinds of risks depending on their investment objective and style.  The level of risk associated with the principal amount invested in a mutual fund involves investment risks such as trading volumes, settlement risk, liquidity risk, and default risk including the possible loss of principal. Within a category, the risk profile of different schemes belonging to that category varies too.

The General Risks of Investing in Mutual Funds also include global, regional, or national economic developments; governmental policies or political conditions; development in the regulatory framework, taxation, law, and legal issues; overall movements in interest rates; fluctuation in currency exchange, broad investor sentiment; and external shocks (e.g. natural disasters, war), etc.  The Net Asset Value (NAV) of the Scheme may also fluctuate with movements in the broader equity and bond markets influenced by factors affecting capital and money markets. As the price/value/interest rate of the securities in which the Scheme invests fluctuates, the value of an investment in a mutual fund Scheme may go up or down. Risks involved in equity, Debt securities, and Money Market instruments:

The ‘Market risk’ is an umbrella term used for multiple types of risk associated with adverse changes in market variables that include Liquidity Risk, Interest rate risk, Foreign exchange rate risk, and equity price risk. Market risk causes substantial changes in the income and economic value of an asset. The Bank of International Settlements (BIS) defines market risk as “the risk that the value of ‘on’ or ‘off’ balance sheet positions will be adversely affected by movements in equity and interest rate markets, currency exchange rates and commodity prices”.

Liquidity Risk: Liquidity risk is the risk of not being able to liquidate the investments at fair value as and when the need arises. Such circumstances can arise due to the lower demand/ decrease in demand due to adverse changes to specific issuers/groups. If the securities held in your mutual fund portfolio are not frequently traded or if their demand is lesser, then the fund manager may be forced to sell these securities at a loss which reduces the NAV of the scheme where you have invested.

Interest rate risk: This risk is due to the negative correlation between the interest rate and the bond price in the market. When the interest rate goes up, the price comes down, and vice versa. It is also dependent on the maturity period of the bond. The longer the maturity period, the more exposure your bond has to the interest rate fluctuation. Hence, low-duration debt funds are considered to be low-risk debt mutual funds.

Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. If your investment in mutual funds is where the fund manager has invested the money in foreign stocks or bonds, currency shift is a significant determinant of how your investment in the mutual fund would perform. For example, a fund manager invested in the US Dollar, and if the dollar strengthens, this would result in your foreign mutual fund investment appreciating and increasing in value. Similarly, if the dollar weakens, your investment could lose value.

Equity shares and equity-related instruments are volatile and prone to price fluctuations daily. Further, the price of a specific share may drop due to a specific company or sector. There is also liquidity risk in certain cases like settlement periods being extended significantly by unforeseen circumstances. While some securities that are listed on the stock exchange carry lower liquidity risk, the ability to sell them is limited by the overall trading volume on the stock exchanges. The inability of a mutual fund to sell such securities held in the portfolio could result in potential losses to the scheme. Should there be a subsequent decline in the value of securities held in the scheme portfolio may thus lead to the fund incurring losses till the security is finally sold.

Risks involved in Debt securities and Money market instruments:

Investing in debt funds carries various types of risk. These risks include Credit risk, default risk (counterparty risk), Interest rate risk, Inflation risk, reinvestment risk, etc.

Credit risks:

Credit risk is one of the primary risks of investing in debt funds. It is the risk of default when the issuers of fixed-income securities fail to meet their obligations according to a specified schedule in terms of a predetermined agreement either due to genuine problems or willful default.  In case of a default, the scheme may not fully receive the due amounts and NAV of the scheme may fall to the extent of default. Corporate bonds carry a higher amount of credit risk than government securities. Within corporate bonds also there are different levels of safety and a bond rated higher by a rating agency is safer than a bond rated lower by the same rating agency.

Counterparty risk:

The counterparty risks (also known as default risks) arise in the transactions of derivatives trading which take place between two parties under a prior agreement with a set of terms and conditions. The parties involved in the trading are referred to as counter-parties (viz. buyer and seller). The counterparty risk is linked with the inability or unwillingness of a customer or counterparty to meet his commitments relating to trading, hedging, settlement, and other financial transactions under the agreement. [Derivatives are specific types of instruments that derive their value over time from the performance of assets like financial futures, swaps, bonds, equities, options (call/put) forwards, etc.].

Inflation risk:

Inflation causes interest rates to rise, leading to a decrease in the value of existing bonds. During times of high inflation, bonds yielding fixed interest rates tend to be less attractive. Not all bonds are affected by interest rates in the same way. The fund managers of your Mutual Funds may be forced to sell these securities during this period at a loss which reduces the NAV of the scheme where you have invested.

Re-investment Risk:

Investments in fixed-income securities carry re-investment risk as the interest rates prevailing on the coupon payment or maturity dates may differ from the original coupon of the bond (the purchase yield of the security). This may result in final realized yield being lower than that expected at the time. The additional income from reinvestment is the “interest on interest” component. There may be a risk that the rate at which interim cash flows can be reinvested is lower than that originally assumed.

Watching the growing number of retail participation in mutual funds, SEBI has tried to make it easier for retail investors to understand the risk through a risk-o-meter.