Understanding the risks associated with Mutual Funds

Understanding the risks associated with Mutual Funds

Risk is an indispensable part of any investment activity. Though different kinds of investments may rank differently across the risk spectrum, no investment is entirely risk-free. The same holds for mutual funds.

But what exactly does one mean by the word ‘risk’? In the world of investing, risk refers to volatility or fluctuations in price. Thus, investments that are highly prone to wild changes in either of the two are deemed to be highly risky. Both equity and debt funds carry some amount of risk, though the latter is generally less risky than the former. Equity tends to be highly volatile, especially when considered in the short to medium term.

A riskometer is the most basic tool which helps to ascertain the inherent risk of a mutual fund. All mutual funds carry a riskometer, which helps to point out the inherent risk of the scheme.

Here is how different categories of equity funds rate on the riskometer. Aggressive hybrid funds are the least risky of all since they can invest as much as 35 percent of their assets in debt. What follows next are large companies, since these don’t fluctuate that wildly. Mid and small caps have comparatively high risks associated with them since these also fluctuate wildly. The riskiest of all are thematic and sectoral funds.

When it comes to debt funds, here is how they rank in increasing order of risks. Liquid funds are the safest, followed by ultra-short, short, and medium duration funds. Credit risk funds, dynamic bond funds, and long term gilt funds are all on the other side of the spectrum and are associated with higher risks.

What one must beat in mind concerning debt funds is how the risk associated with them is two-fold; for it has both interest and credit risk associated with it.

Interest risk is the risk of the interest rates fluctuating unexpectedly. When interest rates rise, bond prices fall or goes up. Thus, a fund that holds long-duration bonds is naturally subject to higher risks.

Credit risks are the risk of a default by the bond issuer. Those debt funds that invest in a relatively lower-rated paper have more chances of this risk.

Mutual funds are also associated with several other risks, which can be minimized if the investor makes prudent decisions. For instance, investing across multiple fund houses and schemes can reduce fund-manager specific, fund-house specific, and scheme-specific risks. Portfolio risk can also be reduced by adhering to multi-cap equity funds.