Mutual funds can be exposed to many risk factors, including in market, interest rate and liquidity. They also have credit, default risk, currency and political exposures because they invest in securities that could be susceptible to these risk factors. Mutual funds diversify their risk by investing across asset classes, credit classes and market caps.
Every investment option comes with risk. Higher returns are associated with higher risk investments. Mutual funds are no exception. Mutual funds invest in a variety of securities, including international securities, bonds, equity, and gold. They are subject to the risks of each asset class they invest in.
Let’s look at the different types of mutual funds risks and their purpose. Mutual funds are investment vehicles that invest other securities. They bear the risk of those securities but there is a risk associated with each asset type. All mutual funds have different risk levels depending on what type of investment they make. Mutual funds invest primarily in securities that can be traded on any exchange. Market risk is the biggest risk factor for any security that is listed on an exchange. Demand-supply is the main driver of the security’s price. The security’s price is therefore likely to fluctuate on a daily basis. Because mutual funds invest in these securities, their NAV moves with the price fluctuations in the securities in their portfolio.
The point to remember is that mutual fund investment has a lower risk than investing in the underlying securities directly. It is easy to see why. Direct investment in stock stocks means you are subject to any price fluctuations. A mutual fund portfolio contains many stocks from different markets and sectors. The portfolio is well-diversified so that the risk of stocks moving up or down can be minimized. A mutual fund portfolio has a lower impact on price fluctuations than direct investing.
Mutual funds are also exposed to market risk. They are vulnerable to liquidity, credit default, currency and interest rate risks. Interest rate changes are very significant for fixed income securities. Fixed income funds and debt funds will be more vulnerable to interest rate risks. Fixed income securities are also susceptible to credit risk and default risk.
Businesses that trade in goods and services are more susceptible to currency risk. An IT company’s stock is more susceptible to currency fluctuations than a FMCG or FMCG company that sells only in the domestic market. All companies are affected in some way by currency movements, as oil prices can affect them all. Every business is affected by the price fluctuations of oil. Similar to stocks and bonds, macroeconomic factors can also have an impact on mutual funds.
Macroeconomic factors include inflation, rate of economic growth and employment rate. These factors have an impact on every business and all securities are affected.
When mutual funds invest in securities that aren’t traded often or aren’t liquid, they run the risk of liquidity. The lack of liquidity in the market can cause mutual funds to not receive the best price when transacting in these securities. This creates liquidity risk for the portfolio.
You shouldn’t assume mutual funds are loaded just because we have discussed so many risk factors. Although they carry a higher risk than traditional savings avenues such as bank FDs or post office saving schemes, their portfolios are designed to diversify unsystematic risks to a large extent. Unsystematic risk is the risk associated with individual securities, such as the currency risk in IT company stocks or the credit risk in corporate bonds. It is possible to achieve this by having a variety of securities, so that their risk factors are balanced out one another. Fund managers don’t eliminate all unsystematic risk. They look at creating alpha, i.e. more than the benchmark by selecting high-performing stocks. Is it not prudent to invest in mutual funds now rather than directly in the market?
Professional fund managers are skilled in managing mutual funds. They have spent years studying different companies and their financial performance. These fund managers make sure that any security they include in their portfolio is well researched and analysed before making a decision. You wouldn’t be able to pick the best stocks from the many thousands or millions of securities traded in the market if you were an individual. When you think about investments, think mutual funds . Now you will be able to appreciate the advantages of mutual fund .
