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Types Of Mutual Funds And Associated Risks Explained!
Mutual funds make up for the best investment option for beginners and experienced investors. Mutual funds are a place where multiple individuals and institutional investors pool in money. The fund house then invests the collected money into a variety of assets such as equities, debts, hybrid funds, and other such money market instruments. Before investing in any of these assets, the fund managers conduct thorough research to gain maximum capital appreciation and generation of income.
There is an array of mutual funds available which suits the needs of the investors. However, the popular ones are as mentioned. These carry different risk levels as well. Some are low-risk mutual funds while others carry high-risk.
1) Equity funds: These funds primarily invest 65 per cent of their assets in equities which are stocks or shares of companies. They are usually high-risk mutual funds
2) Debt funds: Such funds predominantly invest 65 per cent of their assets in debt and money market instruments
3) Hybrid funds: These funds invest in at least two asset classes among equity, debt, gold, etc. They are usually a combination of equity and debt funds
Investors who are aiming for a long-term investment option, mutual funds are ideal. They are professionally managed, has the potential to generate high returns, and is a low-cost investment. As mentioned earlier, every type of mutual fund carries some level of risk.
Following are the ways low and high-risk mutual funds are broken down:
1) Equity funds: They are known to offer the best returns but carry maximum risks –
• Volatility risk: Since 65 per cent of its assets is into equity and equity related instruments, the performance of the companies matters. Performance of the company relies on prevailing macroeconomic conditions such as changes concerning Government, SEBI and RBI policies, economic cycle, consumer needs, etc. These directly impact the stock price of the company favourably or unfavourably. This can cause an upward or downward movement in the value of the shares. Generally, large-cap companies are less prone to volatility. Similarly, diverse equity funds do not face the negative impact.
• Management risk: Company management refers to the team that is responsible for leading the organisation in the right direction. If there are any changes in the administration such as pledging shares, increase or decrease in promoter stake, etc. it directly impacts the stocks of the company. Other aspects like mismanagement, conflicts in the team, and so on can also downgrade the price of the shares.
• Liquidity risk: You must opt for equity funds only if you aim for long-term investment. It is difficult for investors to buy or sell equity investments to make a profit or minimise the losses. This could lead to a scenario where the scheme does not offer enough liquidity to meet redemption needs. To reduce such risk levels, investors invest a portion of their funds in debt and money market instruments to receive high liquidity.
2) Debt funds: They are relatively low-risk mutual funds. But they do carry some level of risk –
• Interest rate risk: Interest rates and debt funds are inversely related. When the interest rates go up, debt funds are less lucrative, and thus prices drop. Similarly, when the rates go down, the bond prices hike. The interest rate sensitivity varies from one debt fund to the other.
• Credit risk: Debt funds invest in an array of debt and money market instruments such as corporate bonds, certificate of deposits, commercial papers, etc. The creditworthiness of such funds varies based on issuer and are determined by credit ratings, provided by credit agencies like CRISIL, ICRA, Fitch, and Brickworks. A high debt instrument includes a high level of creditworthiness.
• Inflation risk: Bonds and money market instruments are mostly fixed because they include a fixed coupon rate. Hence, inflation tends to erode coupon rate depending on the interest earnings that the debt fund can receive. This lowers the potential returns. Meanwhile, lower inflations push the bond prices.
Swarali Chavan is a finance professor who loves study about market investment instruments. She has written on low-risk mutual funds. Through this article, she has explained the associated risks for each type of fund
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