Is investing in Mutual Funds a safe option?

Let is understand whether mutual funds are safe and what are the risks associated with investing in mutual funds.

Dec 19, 2019 10:12 IST India Infoline News Service

Mutual Funds
In the financial markets, risk is essentially a relative term. There is nothing like a risk-free investment when it comes to any asset class. Let us look at some of the anomalies pertaining to risk.
  • Equities are considered to be relatively risky, but they manage risk better in the long run. Over a longer time frame, debt funds run the risk of not taking enough risk.
  • Mutual funds are run by professional fund managers who select and diversify your portfolio. But fund selection can be a risk in mid cap funds and credit risk funds.
  • Mutual funds offer a wide choice to select from but that also adds to the risk of investors selecting funds that may not sync with their long term goals.
That brings us to the basic question; are mutual funds safe? The answer is they are relatively riskier than government bonds but less risky than direct equities. Let us look at some key mutual fund risks and these go much beyond the mutual fund risk factors that you get to see as part of the statutory disclosure.
 
Mutual fund risks in your portfolio
As we said earlier, risk is not unique to equity funds alone. There are risks in debt funds, gold funds and liquid funds too. Here is a quick rundown.
 
Equity volatility risk
 
You must have seen the VIX shoot up and the Nifty and Sensex gyrate wildly. This could be due to domestic factors, global factors, FII selling or valuation fears. The bottom-line is that it causes volatility in the NAVs of equity mutual funds, including index funds. Volatility is a proxy for risk in the stock markets. In technical parlance, this is also known as systematic risk. These risks cannot be handled by diversification as it tends to hit all stocks in the market. However, many mutual funds do create beta hedges using Nifty futures to take care of this aspect of equity fund risk.
 
Risk of concentration in themes
 
This risk exists in equity funds and debt funds. For example, if your equity fund is concentrated on commodities, then commodity down-cycle can damage portfolio performance. Similarly, a long duration portfolio in a debt fund can also get hit by rising interest rates in the market. The risk of concentration is most pronounced in very specific types of funds. For example, sector funds are focused on one or two industry groups, and hence, the level of concentration risk is very high. Secondly, credit risk funds within debt funds also have a high concentration risk due to exposure to corporate credit cycles. One way to handle this risk is through portfolio diversification by spreading across themes.
 
Bond price risk or interest rate risk
 
Shifts in interest rates impact equities too but the real impact is on bonds. Interest rates and bond prices are inversely related, and hence, a rise in interest rates leads to rise in bond yields and a fall in bond prices. This reduces the NAV of bond and other debt funds. Of course, since liquid funds are of very short duration, the impact of interest rate risk is minimal. The interest rate risk is highest in the case of long duration bond funds that are predominantly invested in government securities.
 
Risk of illiquidity in mutual funds
 
Liquidity risk has two interpretations with respect to mutual funds. Firstly, we can refer to the liquidity of the portfolio. For example, mid cap funds and small cap funds in the equity segment normally face liquidity risk when it comes to entry and exit from these stocks. They are less liquid and the impact cost can be quite high. Secondly, there is the risk of liquidity in closed-ended funds as they are not available for purchase and redemption. In such cases, the liquidity discount in the market can be quite steep.
 
Default risk or credit risk
 
This is not a risk with central government debt as they are regarded as blue-chip. However, state government bonds, municipal bonds and corporate debt do carry credit risk. While credit ratings are a defence mechanism, these ratings can go awfully wrong as we have seen in the case of companies like IL&FS, DHFL and Jet Airways. Credit risk means that the issuer is unable to service the debt. As a result, the mutual fund is also forced to either default or restructure payments; as we saw in the recent case of Essel Group.
 
Risks are a part and parcel of mutual fund investing, irrespective of the type of fund you choose. The best you can do is diversifying to manage the risk effectively.

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