We invest in gold, real estate, and insurance without thinking about their poor returns or the loss of our principal. But the case differs when we take up stock market investments. We are ready to take frequent risks in equity investments. We stick to these long-term stock market investments even if we lose money.

 

However, owing to the diversity of equities in a Mutual Fund’s Assets Under Management (AUM), it has a lower relative risk than equity investments. This is because the fund managers invest money in various companies per the mutual fund’s investment goals. So, even if a few stocks do not perform well, they have little impact on the portfolio.

 

This reduced investment risk is the result of diversification. Moreover, it gives the leeway for the investors to follow an ‘invest and forget’ attitude with mutual funds. On top of that, they believe that the responsibility of capital allocation rests on the fund manager’s shoulder and doesn’t require any effort from their side.

 

Risks involved in Mutual Funds

 

Mutual fund investors have two significant concerns. First, whether they can attain adequate capital gains without losing their principal. Second, the credibility of the mutual fund company. The Securities Exchange Bureau of India (SEBI) and the Association of Mutual Funds in India (AMFI) will address the latter concern. These government organizations oversee and supervise every domestically operated mutual fund.

 

Here is a list of factors that could help you deal with the former concern regarding mutual fund investments.

 

1. The Market Risk

 

The money invested in an equity-based mutual fund goes into publicly-traded companies’ shares. As a result, equity-based mutual funds, or any mutual fund having partial holdings in equities, are exposed to the volatility of stock markets. Volatility refers to the frequent price fluctuations in the stock markets owing to various international and domestic factors.

 

2. Credit Risk

 

All debt-based mutual funds that invest in fixed-income debt instruments like debentures and bonds are exposed to credit risk. In the case of these securities, the government and public companies are borrowers, and the mutual fund is the lender. So, the borrower must commit to return the principal and interest within the maturity period of the debt. If it doesn’t happen, every investor in the mutual fund should suffer a loss of capital.

 

3. Interest Rate Risk

 

Bonds are traded in the markets in the same way as stocks. Their price fluctuates with the change in interest rates and other economic conditions. Despite this volatility, they offer steady returns as interest payments. Every debt fund carries interest rate risk as the relationship between bond prices and the interest rates are inversely proportional. When the interest rates (the cost of borrowing) go up, the debt funds become less attractive and vice-versa.

 

4. Inflation Risk

 

Inflation refers to an increase in prices owing to a fall in a country’s currency value. Inflation risk is simple logic that with the decrease in the value of a currency, investors’ purchasing power also comes down.

 

A Few Key Metrics for Evaluating A Mutual Fund

 

There is no such thing as a safe, risk-free investment. By the way, the risk is only one of the few things an investor should look out for in mutual funds. We have already discussed the risk factors associated with mutual funds. Let’s go through some factors that can help investors decide whether a specific mutual fund fits their investment objectives.

1. Returns

 

A well-managed mutual fund may produce a return that beats the return of typical financial vehicles such as Fixed Deposits (FDs) or Recurring Deposits (RDs). The prime aim of a mutual fund is to generate significant returns from the securities markets. An investor must look for an average annual return of 12%. The funds invested in specific sectors may perform better or worse than the market. So, check the industry or index your mutual fund of choice has invested in to gauge its estimated returns before investing.

 

2. Uncertainty

 

Uncertainty and unpredictability accompany every investment opportunity. Therefore, mutual fund investments that employ a systematic investment strategy are always relatively safer. But what might happen when an investor, for whatever reason, couldn’t contribute to his mutual fund? Does the mutual fund forfeit or nullify his deposits? Never. Mutual fund investors can suspend their payments until they can resume them. The conditions and the period of suspension vary as per the policy of the fund management company.
 

This ability to deal with uncertainty makes mutual funds a better investment option than FDs or RDs. The bank deposits usually get terminated in case of default in payment.

 

3. Liquidity

 

Suppose you have contributed to a Systematic Investment Plan (SIP) mutual fund for 10 years and have reaped substantial returns. Now, you desire to send your children abroad for higher studies. Unfortunately, an education loan with an interest rate as high as 12 percent would burn a deep hole in your pocket.

 

A liquid mutual fund helps you deal with this scenario without taking a loan. All you have to do is to liquidate the mutual fund and utilize the capital gains to pay for your children’s education.

 

4. Tax Benefits

 

Mutual funds are tax efficient relative to other investment instruments as long, and short-term returns are taxed differently. So, investors should hold their investments for appropriate periods to save on tax. Moreover, some mutual funds, such as Equity Linked Savings Schemes (ELSS), are specifically designed for tax benefits.

 

The Bottom Line

 

No matter the instrument, investing is always a game of risk. Therefore, taking any investment vehicle, including mutual funds, as ‘risk-free’ could be fatal to anyone’s portfolio. For example, equity-based mutual funds give you greater returns but have higher risks. You can choose those investments if you have a higher risk appetite. On the contrary, if you have a low-risk appetite, go for debt-based mutual funds. They come with lower risk only to give you lower returns. If you need the good in both worlds, try hybrid mutual funds.

 

Justin Raj

 

Alpha Research Team