How mutual funds are relatively stable investment option

Mutual funds have emerged as an attractive investment option for investors, as indicated by sharp growth in industry assets (~14% rise in the average asset under management (AUM) since September 2010), totalling over Rs. 16 trillion1 at last count.​ Professional fund management, diversification, liquidity and reasonable cost build a strong case for mutual funds. But the often ignored characteristic is that investments are marked to market (MTM), i.e. returns are subject to movement in the underlying asset class and, hence, carry certain risks. This article details the risks and highlights how to circumvent them.

Mutual fund regulation in In​dia​​

The mutual fund industry in India is regulated by the Securities Exchange Board of India (SEBI) under the Mutual Funds Regulations of 1996. SEBI has worked towards protecting investor interest through various regulations and guidelines. All mutual funds, whether promoted by domestic public or private sector entities or foreign entities, are governed by the same set of regulations.

The Association of Mutual Funds in India (AMFI) is the mutual fund industry’s representative to the government, the Reserve Bank of India and other bodies. Set up in August 1995, AMFI comprises all SEBI registered mutual funds in India. Maintaining high professional standards, protecting the interest of investors/unit holders and regulate conduct of distributors are some of its key functions.​

Chart 1 – Benefits of mutual funds

 

1 Average asset under management data by AMFI

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 capitalise 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 minimise losses.

• Credit r​​isk – 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 its net asset value (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. To make it easier for investors to identify schemes with their risk-return profile, market regulator SEBI has made riskometer a compulsory addition to scheme literature; it is an indicator of the risk a scheme carries. Earlier, risk was identified by product labeling - three colors.

The riskometer operates on a 180-degree scale, where the arrow indicates the extent of risk involved and, thus, helps investors make choices based on their appetite.

Chart 1 – Benefits of mutual funds

The riskometer has five categories: Low - principal at low risk Moderately low - principal at moderately low risk Moderate - principal at moderate risk Moderately high - principal at moderately high risk High - principal at high risk ​

The riskometer is displayed on the front page of scheme related documents and advertisements. After reviewing personal parameters such as goals, income levels, age, financial commitments, investment horizon and liquidity requirements to evaluate their risk-taking capacity, investors can just check the riskometer.

Disclaimer : Any information contained in this article is only for informational purpose and does not constitute advice or offer to sell/purchase units of the schemes of SBI Mutual Fund. Information and content herein has been provided by CRISIL Research, a Division of CRISIL Limited, and is to be read from an investment awareness and education perspective only. The views / content expressed herein do not constitute the opinions of SBI Mutual Fund or recommendation of any course of action to be followed by the reader. Investors should consult their financial advisers before taking any investment decision.

Mutual Fund investments are subject to market risks, read all scheme related document carefully.​