Mutual funds are market linked instruments, which invest in equity or equity related securities, debt and money market instruments. The Net Asset Value (NAV) of a mutual fund scheme depends on the market price of the underlying securities in its portfolio. Prices of these securities can go up or down depending on market movement. Hence, you see the disclaimer “mutual funds are subject to market risks”, in fund literature.
Is mutual fund safe?
Investors who have invested only in traditional fixed income investments like Bank Fixed Deposits, Post Office Small Savings Schemes etc., often have two questions when they first invest in mutual funds. (1) How much return will I get? (2) Is it safe to invest in mutual funds? It is very important for investors to understand the following:-
- Mutual funds do not give assured returns.
- Even if a mutual fund scheme is paying regular dividends, dividends (IDCW) paid by mutual funds are not assured. The Asset Management Company (AMC) can change the dividend (IDCW) payout rate or can even stop paying dividends for a period of time, as deemed fit by the AMC based on market conditions.
- There is no guarantee of capital protection in mutual funds.
You should be prepared to take some risks when investing in mutual funds. But if you understand the risks and make informed investment decisions based on your risk appetite and financial objectives, mutual funds can provide investment solutions for a wide spectrum of the risk appetites and investment needs. In this article, we will try to understand the risks in mutual fund investing and discuss is mutual fund safe.
Risks in equity funds
There are three kinds of risks in equity mutual funds. They are as follows:-
- Market risk: Market risk is also known as systematic risk. This is the risk which affects the entire stock market. It can be caused by events which may affect the entire economy e.g. investment cycles, Government policies, RBI actions, global events e.g. COVID-19 pandemic, Global Financial Crisis, 9/11 terrorist attack in New York etc. Market risk can cause volatility in your mutual fund investments. Some categories of mutual fund e.g. midcap funds, small cap funds etc., are affected more by market volatility compared to other categories e.g. large cap. You should invest according to your risk appetite without thinking about how safe is mutual funds.
- Unsystematic risk: This is the risk which impacts only a particular stock or sector. Mutual funds aim to diversify unsystematic risk, but there may still be some unsystematic risk in actively managed funds because fund managers may be overweight / underweight on some stocks / sectors in order to beat the market benchmark index i.e. create alphas for investors. If you want to avoid unsystematic risks, then you may invest in ETFs and index funds, which track market indexes and are subject only to market risks. However, investors should understand that unsystematic risk is not necessarily bad risk because it can help the fund managers give superior returns over sufficiently long investment horizons i.e. create alphas for investors. You should invest according to your risk appetite and investment needs without worrying about is it safe to invest in mutual funds now.
- Liquidity risk: This can arise due to inability of the fund manager to sell the underlying securities of scheme when the need arise e.g. redemption pressures. If there are not sufficient buyers due to prevailing market conditions e.g. very high volatility, bear market etc., a fund manager may be unable to sell the securities. In extreme market conditions, the AMC may stop redemptions in certain mutual fund schemes. Liquidity risk in equity funds impact some market segments e.g. small cap funds compared to other more liquid segments e.g. large caps.
Risks in debt funds
There are three kinds of risks in debt mutual funds. They are as follows:-
- Interest rate risk: Bond prices are affected by interest rate changes. Bond prices go up when interest rate goes down and vice versa. Interest rates can change for a variety of reasons viz. RBI actions, higher Government borrowings, currency depreciation etc. Debt funds are impacted by interest rate risk. However, some types of debt funds are more affected by interest rate risk than others. Longer the duration of a debt fund, higher is the sensitivity to interest rate changes. You should invest according to your risk appetite and investment needs. If you want to minimize interest rate risks, you should invest in shorter duration debt funds without worrying about is mutual fund safe.
- Credit risk: Credit risk of fixed income instruments refers to the issuers’ failure of meeting their interest and / or principal payment obligations, exposing the investor to potential loss of income and / or capital. If the issuer defaults on interest and principal payments then the price of the instrument will be written down permanently and the investor may have to suffer a loss. That is why credit risk is the most damaging risk, as far as fixed income securities are concerned. Is it safe to invest in mutual funds that to in debt funds, the answer is that you should avoid credit risks by investing in debt mutual funds of high credit quality rating.
- Liquidity risk: Question of liquidity makes investor think is it safe to invest in mutual funds. We discussed this in context of equity funds. However, liquidity risks are also relevant to debt funds, as it relates to the inability of the fund manager of debt fund scheme to sell the underlying securities of scheme when the need arise e.g. redemption pressures. Liquidity risk in debt funds is primarily linked with credit risks, i.e. with schemes which have suffered from defaults in the underlying debt and money market instruments. A debt scheme may segregate the illiquid assets into a segregated fund and try to recover the money for investors, but the recovery timelines may stretch over a period of time. Though this risk usually manifests in extreme market conditions, investors should be mindful of this risk and make informed investment decisions.
Other types of risks
- Sector risks: A particular industry sector may outperform / underperform the broader market in different market conditions. Though any diversified equity fund which is overweight on certain sectors are subject to sector risk, a mutual fund scheme which invests in particular sector e.g. sector funds are exposed to higher sector risks. While a sector fund can outperform a diversified equity fund during a certain period, a sector fund can also underperform over a certain period, if the sector itself is underperforming the broader market for any number of reasons. If you are low risk taker and think is it safe to invest in mutual funds, you should avoid sector and thematic funds.
- Concentration risk: Concentration is the opposite of diversification. If a mutual fund scheme invests a relatively large percentage of its assets in a few securities, then the underperformance of those few securities can have a significant impact on the scheme performance. Concentration risk can impact both equity and debt funds. As far as diversified equity funds are concerned, concentration risk is mostly relevant for focused funds. While focused funds have the potential of creating higher alphas, it also has higher concentration risk – you should make informed investment decisions based on your risk appetite. Issuer concentration risk is also very relevant for debt funds. SEBI has guidelines for concentration risk as far as debt funds are concerned, but as an investor, you should also check the concentration risk of a scheme before investing.
- Currency risk: This is the risk of your scheme performance being affected due to the foreign exchange rate changes. Currency risk primarily impact international funds or funds which have significant exposures to foreign securities. It may also impact returns of Gold ETFs and Gold Funds. Currency risk can also work in favour of International Funds and Gold Fund investors, if the Indian Rupee (INR) is depreciating versus the US Dollar (USD).
Invest according to risk profile
Mutual funds offer products covering a large spectrum of risk profiles to suit different risk appetites. Instead of thinking is it safe to invest in mutual funds now, you should know the risk profile of a mutual fund scheme to ensure that you are taking the right amount of risk. Equity funds are suitable for investors with moderately high to high risk appetites. Debt funds are suitable for investors with low to moderate risk appetites. Within the broader equity, debt and hybrid fund categories, there are various sub-categories. SEBI requires mutual funds to label the risk profile of each scheme on Riskometer. A Riskometer has 6 risk levels ranging from low to very high. You should select the appropriate risk profile depending on your risk appetite. You should consult with a financial advisor and discuss is mutual fund safe and take his/her help to understand your risk appetite and risk profile of the scheme where you want to invest.