Understanding Risks In Mutual Fund Investing

Mutual funds carry risks owing to the fact that they invest in a diverse variety of volatile financial instruments such as equities, corporate bonds, government securities, and many more. Armaan Madhani sheds light on the various kinds of risks and how they can be measured [EasyDNNnews:PaidContentStart]

To quote famous radio talk show host Barry Farber, “There is no reward in life without risk.” On similar lines, we can say that there is no investment that furnishes returns without risk. All investments are subject to some risk. Mutual funds are one of the most popular investment instruments. They are convenient, diversified and professionally managed which often deliver attractive returns. Yet, although mutual funds are considered to be relatively safe investment tools, their performance depends on the prevailing market variations. Upon hearing the words ‘mutual funds’, the classic disclaimer “mutual fund investments are subject to market risks” immediately rings a bell in our minds. 

Though mutual funds offer broader diversification and value-for-money to retail investors, there are numerous risks associated with investing in mutual funds. Mutual funds carry risks owing to the fact that they invest in a diverse variety of volatile financial instruments such as equities, corporate bonds, government securities, and many more. Each of these securities fluctuates differently in markets on the back of almost countless number of factors, eventually leading to profits or losses. In this cover story, we delve deep to procure a better understanding of the different types of risks in mutual funds as well as explore the distinct parameters used to measure and analyse risk. 

Types of Risks in Mutual Funds

Market Risk
Market risk is also known as systematic risk. It is the most common and generic risk for any and every investment instrument. Market risk affects all securities in the same manner due to the poor performance of the market and the economy as a whole. Market performance can get impaired due to a slew of factors such as geo-political crisis, inflation, recession, gyrations in interest rates, occurrence of natural disasters, and so on. The type of market risk that applies to mutual funds depends on the assets held in its portfolio i.e. equity or fixed income. 

Liquidity Risk
It is the risk of not being able to sell or redeem an investment security easily or quickly because of the prevalence of highly illiquid conditions. It occurs when a seller is unable to find a buyer for a security. The liquidity condition in a market varies from time to time due to many reasons such as increase in interest rates, changes in currency value, etc. In a tight liquidity environment, the necessity to sell securities may lead to higher impact cost, provoking a loss to the seller. Occasionally small-cap funds and small-cap ETFs tend to pose liquidity risk in bear markets. 

Interest Rate Risk
Interest rates reflect the availability of credit in an economy. The financial state of an economy significantly influences interest rates. Interest rate risk primarily applies to debt mutual funds. The prices of debt mutual fund schemes and the interest rate are typically inversely proportional to each other. Increase in interest rates causes the prices to decrease which erodes capital gains and vice-versa. While Debt Funds are impacted negatively due to increase in interest rates, it may also lead to a decline in the value of equity mutual funds over the short run due to higher borrowing costs and flagging consumer demand. Ergo, an investor must consider interest rate movement before investing. 

Credit Risk
The risk associated with a bond defaulting on the grounds of non-payment by the issuer of the security is known as credit risk or default risk. If the issuer is unable to fulfil the repayment obligation, the security might end up being a worthless investment. Securities with a higher risk of default tend to pay higher returns. Particularly, debt funds suffer from credit risk. Reputed agencies give ratings to fixed income securities such as bonds or debentures based on the risk associated. A fund manager might invest in instruments with lower credit ratings in order to generate superior returns. 

Inflation Risk
Inflation risk refers to reduction in investors’ purchasing power due to the rise in the general level of prices of various goods and services over time. In simple terms, to maximise the real rate of return, the total return earned should be more than the prevailing inflation rate. For example, if the money invested in mutual funds delivers a 10 per cent return while the general inflation rate stands at 6 per cent, your net purchasing power increases by 4 per cent. If inflation is improperly accounted for, an investor might fail to meet his or her financial goals and have a shortfall of funds. 

Country and Currency Risk
Country risk refers to the uncertainty associated with investing in a foreign country. The uncertainty can arise from a variety of factors such as economic, political, and so on. Currency risk arises from change in the price of one currency in relation to another. It is commonly referred to as ‘exchange rate’ risk. Fluctuations in domestic currency with respect to foreign currencies add unwarranted risk to mutual funds. This risk is more predominant in short-term investments, which lack ample buffer period to level off their investment in foreign assets. Both country and currency risks are associated with mutual fund schemes that invest internationally. 

Other Risks
Portfolio rebalancing is the act of adjusting portfolio asset weights in order to restore target allocations or risk levels over time. Fund managers frequently rebalance their portfolios. However, rebalancing can often be accompanied by the risk of losing out on future growth opportunities. It also increases costs due to transaction charges from recurrent buying and selling. Reinvestment risk is the likelihood that a fund manager will be unable to reinvest cash flows received from securities at a rate comparable to their current rate of return. Investments in fixed income securities carry reinvestment risk. Reinvestment risk is high for bonds with long maturities and high coupons. 

Concentration risk arises when investors allocate a big chunk of their funds into a single scheme or a particular sector. Being a high-risk high-reward strategy, it is not considered a good practice as it is more prone to losses. The risks associated with the team responsible for managing an investment fund is called management risk. The performance of any scheme is dependent on the experience, knowledge, expertise, process and ethics adopted by the fund manager and a deficiency in any of these criteria would adversely impact the fund’s performance. 

Ways to Measure Risk in Mutual Funds 

Standard Deviation — Standard deviation measures the total risk of a mutual fund. It indicates the volatility of the fund’s returns. It refers to how much a fund’s return is deviating from the expected returns based on its historical performance. Higher standard deviation indicates higher volatility in returns. For example, if a scheme has a standard deviation of 5 per cent and an average return of 15 per cent, it implies that returns have a tendency of deviating by 5 per cent from its average return and may furnish returns in the range of 10-20 per cent. 

Sharpe Ratio — Sharpe ratio measures the risk-adjusted performance by using standard deviation. It is calculated by dividing the excess return earned by the fund over the risk-free rate i.e. government securities by the standard deviation of the fund’s returns. The ratio helps an investor understand whether the returns being earned are on account of wise investment decisions or excessive risk. A higher Sharpe ratio implies higher returns being generated for every unit of risk that was taken. 

Sortino Ratio — Sortino ratio is similar to Sharpe ratio as it also measures the risk-adjusted return. However, instead of using the fund’s standard deviation it employs the fund’s downside standard deviation in its calculations. Downside deviation measures the risk and price volatility of an investment by comparing returns that fall below the average annual return to minimum investment thresholds. Upside volatility is beneficial to investors and often isn’t a cause of worry. Higher Sortino ratio reflects a lower probability of downside deviation in a mutual fund scheme. 

Alpha — Alpha is the return earned by an investment in excess of the return on a benchmark index. The fund’s alpha shows the fund manager’s stock and sector allocation skills. A negative alpha means that the fund has underperformed the benchmark while a positive alpha means that the fund has performed better than the benchmark on a risk-adjusted basis. For investors, the higher the alpha the better! 

Beta — Beta is a measure of the volatility of the mutual fund portfolio to the market. It refers to the sensitivity of a mutual fund in association with market movements. Beta is measured against a benchmark and the default beta of the stock market or benchmark will always be 1. A beta higher than 1 indicates the fund is more volatile than the market. While a beta below 1 denotes the fund is less risky relative to the market. Conservative investors focus on low beta securities and vice-versa. 

R-Squared — R-squared is a statistical measure that reflects the percentage of a fund’s movement that can be explained by movements in a benchmark index. R-squared values range from 0 to 1, where 0 represents no correlation and 1 represents full correlation. A mutual fund with R-squared value between 0.75 and 1 signifies that the fund’s performance record is closely correlated to the index. A fund’s beta must be evaluated in conjunction with the R-squared to obtain a better understanding of risk. A higher R-squared indicates a more useful beta variable. 

Yield to Maturity — Yield to maturity (YTM) is the total returns expected based on the assumption that the bond is held to maturity and the recurring cash flows i.e. coupons are ploughed back into the bond. A fund’s YTM can be an indicator of risk when compared to the overall fund category’s YTM. For example, if YTM of the overall fund category and a particular fund from the category stand at 5 per cent and 7 per cent, respectively, it implies that the fund is taking on additional risk chasing higher yield. Ideally, a fund’s YTM should match or be slightly lower than the category’s YTM. 

Modified Duration — Modified duration is a measure of how much the price of a fund changes because of the change in its yield to maturity (YTM). For example, if the modified duration of a fund is three years and the market interest rate slips by 1 per cent, then the fund’s price will surge by 3 per cent. On the contrary, if the interest rate rises by 1 per cent, the fund’s price will drop by 3 per cent. If an investor wants to minimise interest rate risk, then debt funds with lower modified duration would be the ideal choice. If interest rates are expected to decline in the future, then investors must opt for funds with higher modified duration. 

Risk Profile of Mutual Funds

The tables below exhibit a comprehensive list of numerous categories of equity and debt funds with their average three-year CAGR returns coupled with the risk parameters described above. 

Conclusion

In simple terms, risk in investing is the possibility of an investment’s actual returns being less than the expected returns. While investing, investors typically tend to focus exclusively on historical returns, failing to consider the risks involved. The degree of risk in mutual funds differs from one scheme to another. If the returns being furnished by a scheme are not commensurate with the risks associated, then making such an investment may not be fruitful. Hence, it is paramount for investors to understand the risks involved, correctly interpret the risk parameters and identify their risk profile in order to select the most appropriate funds to optimise returns. 

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