The Risks associated with Mutual Funds and How to mitigate them?
Every type of investments carries risks. Mutual funds are no different. Learn different types of risks associated with mutual funds & how to mitigate them:
“Mutual funds are subject to market risk. Please read scheme documents carefully before investing.”
All mutual funds have the above disclaimer. So, what is market risk? Why should investors be aware of that before investing in mutual funds?
There are two broad categories of risks, Systematic Risk & Un-Systematic Risk. Market risk is also known as systematic risk. Systematic risk is non diversifiable while Un-Systematic risk can be reduced through diversification.
Systematic risk impacts the whole market and the reasons can be many including war, recession, natural disasters, political unrest, terrorist attack etc.
Since, this risk is non diversifiable, the investor have to bear the same, and wait for the untoward effects on the economy to wear out.
Concentrating your funds or having a large portion of your portfolio in a particular sector or a particular stock could be risky. This could cause amplified losses if the said sector or stock performs badly.
Concentration risk arises due to large investments made in a particular sector. This may be done on a belief that a particular sector will perform better than others. Concentration risk might also arise if different mutual funds in the portfolio of an investor have invested large amounts in one particular sector.
In order to minimize concentration risk, one should spread their investments across different sectors. The investor must review its portfolio time to time and check for concentration risk.
Interest Rate Risk
Interest rate risk is applicable to debt mutual funds. Investor faces interest rate risk between the time of investment and the future target date. Interest rate risk is the uncertainty regarding the ending wealth value of the portfolio due to changes in market interest rates between time of purchase and the investor’s horizon date. If the interest rate changes it will affect the prices of the debt investments. For example: if the interest rates increase after the time of purchase of say bonds, then the prices of the bond will decline. Rising interest rates may have a serious impact on Net Asset Value of debt funds. To minimize the interest rate risk, the investor should match the average maturity of the fund to his/her investment horizon. The other option is to invest in floating rate bond funds.
This type of risk depends on how much time it takes to liquidate a portfolio introduced by the secondary market. When an investor acquires an asset, one expects that the investment will mature or it will be saleable. In either of the cases, the investor is expecting to convert it to cash and use the proceeds for consumption or other investments. The more difficult it gets to convert this into cash greater the liquidity risk. This risk is higher in funds with low Assets Under Management, Small cap funds and the non-government bond funds. In case of distress these funds might not be able to sell their holdings and meet near-term redemption. This type of risk can be mitigated by diversifying the holdings. When the investor spreads the portfolio across various classes of assets then it becomes easier to redeem funds in time of need.
Credit Risk refers to the risk that a borrower may default in repaying the principal amount and interest associated with it to the lender. In context to a mutual fund (debt funds), there is a risk that the bond issuer may default. There are funds which invest in lower credit rating funds as they offer high interest rate. To minimize this risk an investor should check the average credit rating of the fund before investing and invest in the fund having high credit rating.
Risk means that there is a chance that the actual return from an investment will be different from the expected return. It includes possibility of losing some or all of the investment. Hence, it is important to know the risks associated with Mutual funds before investing in them.
Start Investing in mutual funds on WealthTrust App.
New to Mutual Funds? Learn about basics of mutual funds.
– written by Prachi Dosani