Risks in Equity and Debt Mutual Fund Investments

Risks associated with mutual funds

Risks associated with mutual funds are an outcome of the investment in the underlying asset classes, primarily equity and debt.

Equity mutual funds invest in equities and related instruments, and are exposed to market, company-specific, macro-economic and the concentration risks.

Market risk – Equity fund investments enable investors to capitalize on reasonable returns generated by the underlying asset class. On the flip side, value gets eroded during market volatility or downturn. Often the downside risk is limited owing to diversification across stocks and sectors, and the fund manager’s tactical calls to churn the portfolio in response to market movements.

Company-specific risk – Equity funds often invest in companies which are likely future leaders. Failure of such businesses to take off is a grave risk. This is more evident among small cap companies that are more vulnerable than large and mid-caps to a business or economic downturn. Underperformance of the company weakens the scheme’s NAV.

Macro-economic risk – The equity market’s performance reflects developments in the economy (interest rate change, inflation and fiscal deficit trend, currency movement, political stability, central bank policies and tax rates) which, in turn, impacts equity funds. Global factors (economic developments in other countries, policy stance and geopolitical events), too, impact equity funds. Country-specific factors have a greater impact on international equity funds.

Liquidity risk – Such type of risk arises in case of lower trading volume of stocks, which makes it difficult to exit the stock. Liquidity risk is more prevalent in case of penny stocks (extremely low value).

Concentration risk – Some variants of mutual funds cater to a particular segment of the market, such as small or mid-cap or particular sector or stocks. For instance, sectoral funds invest in a particular sector or thematic funds invest in stocks catering to a selective theme such as infrastructure or commodity. Such an investment approach can help harness returns if the sectors perform well, but at the same time carries high risk in case of poor performance of that segment.

Debt mutual funds invest in government securities, corporate bonds, money market instruments and other debt instruments across tenures. Nevertheless, one should consider interest rate and credit risks too. Careful evaluation of funds, based on the individual risk appetite, will help investors select the right funds and minimize losses.

Credit risk – An investor should assess the bond issuer’s creditworthiness and ability to make timely payments (principal and interest). He/she can refer to credit ratings issued by external agencies; lower rating denotes higher credit risk and vice versa. A fall in credit rating drags down the price of the debt instrument and, thus, adversely impacts Mutual Fund NAV. Investors can gauge risks by looking at the credit profile of the debt portfolio. Large investments in sovereign papers or highly-rated debt imply lower credit risk exposure. Typically, gilt funds have lower credit risk as they invest only in government securities vis-à-vis income funds which invest in government securities and corporate bonds.

Interest rate risk - Price of a debt instrument varies inversely with interest rate/yield. The net asset value (NAV) of a debt fund replicates prices of the underlying securities. Hence, when interest rates fall, NAV rises. When rates ease, long-term debt funds benefit more than short-term ones, as they hold longer-tenor securities.

In contrast, prices of short-term funds drop to a lesser extent, as securities mature faster and new securities lock into the lower yield. Investors can measure interest rate risk through modified duration - a measure of a bond’s sensitivity to interest rate movements. Higher the modified duration, more the price fluctuation.

Liquidity risk – This is typically related to how saleable a security is in the market. A debt fund may face liquidity risk if the fund manager finds it difficult to sell it, owing to lack of demand. Funds that have portfolios of low credit quality are more exposed to such a risk. Liquidity risk is especially evident in India, where institutional participants dominate the debt market, and retail investors are few.

Reinvestment risk – This risk arises when cash flows are reinvested at a rate that is less than the coupon rate of the bond. In the falling interest rate scenario, investors may face higher risk as proceeds will be reinvested at a lower rate, thereby reducing returns.

Map risks with your risk-return profile

As explained above, mutual funds have inherent risks associated with the underlying instruments that they invest in, these risks can be circumvented by investing in specific mutual fund categories as per your risk-return profile.