Mutual Fund Risks: Things You Should Know Before Investing

Investments

Mutual funds can be excellent investment options to diversify your portfolio with the possibility of high returns. However, like all investments, mutual funds are not free from risks. Thus If you are thinking of investing in mutual funds, you must learn about the mutual fund risks to mitigate them effectively. 

Here is a list of different types of mutual fund risks that you should check out to maximise your returns. 

What Are The Different Types Of Mutual Fund Risks?

Investing in mutual funds comes with the following types of risks: 

Standard Mutual Fund Risks

• There are investment risks in mutual funds such as settlement, default, liquidity, and other risks.
• Mutual funds do not provide assured or guaranteed returns.
• The value of your investment in a scheme will depend on fluctuations in price, interest rates or the value of securities wherein a scheme has invested. 
• Past performances do not, in any way, guarantee the future performance of a scheme.
• The Net Asset Value of the funds fluctuates with the changes taking place in the equity or bond markets.

Specific Mutual Fund Risks

Apart from the standard risks, there are specific types of risks in mutual funds, specifically with certain schemes. These are as follows: 

Mutual Fund Risks With Equity Investments 

• Risk of losing your money

If you are investing in equity or equity-related instruments, you run the risk of loss of principal. So, make sure to invest in these schemes if you can afford to take the risk of losing money. 

Also Read: Top 10 Equity Mutual Funds To Consider Investing In India

• Liquidity risk

Liquidity mutual fund risk implies risk associated with lowering liquidity that can occur due to various factors such as an increase in interest rate, change in the value of currencies, etc. Those investments that come with a lock-in period may have liquidity risks. 

• Price risk

All equity and equity-related schemes can suffer from price fluctuations on a regular basis. 

• Event risk

Sometimes the prices can fluctuate due to certain sectoral events. 

Mutual Fund Risks With Debt Instruments

• Credit risk

Credit risk occurs when the issuer of a scheme is unable to pay the decided interest. For debt funds, fund managers will usually include securities that come with high credit ratings. However, they will also put in securities with lower credit ratings for higher returns. 

• Interest risk

Changes in interest rates affect the price of debt instruments. For example, when the interest rate climbs, the price of the underlying bonds decreases. Accordingly, the NAV of the fund falls simultaneously.

• Inflation risk 

Inflation risk refers to the risk that the rate of returns from an investment will not be able to keep up with the rising inflation rate. This can significantly diminish your purchasing power. Let’s say your rate of return is 6%, and the prevailing inflation rate is 4%. You will receive only 2% return. 

• Prepayment risk

This risk can arise when a borrower repays a loan before the due date. Borrowers might take advantage of falling interest rates to repay the high-interest loan with funds from the low-interest loan. This can reduce the average maturity of ABS (asset-backed securities). 

• Concentration risk

Concentration risk can take place if you put all your investments into a single mutual fund or sector. In case the sector gets impacted owing to adverse government policy or other reasons, your entire investment will be affected. 

Final Word

Investment in mutual funds will involve risk. To get the most out of your investments, you should be aware of the different mutual fund risks and know how to handle them. In addition, you have to choose funds wisely as per your investment objectives and risk appetite. 

Most importantly, you have to diversify your portfolio in a way to safeguard your investments from all possible risks. 

FAQs On Mutual Fund Risks

1. What is spread risk in mutual funds? 

The credit spreads of corporate bonds can change with altering market conditions. When the credit spread widens, the market value of different debt securities can depreciate. Likewise, for floating rate securities, if the spread on a benchmark index or security widens, the value of the security can also depreciate. This is called spread risk.

2. How can SIPs help tackle mutual fund risks?

Investment through a systematic investment plan or SIP is one of the most efficient ways to reduce mutual fund risks. Through SIP, you can distribute the risk associated with mutual funds. Moreover, with the benefits of compounding and rupee cost averaging, you can reduce the cost of investment.

3. How to tackle inflation risks? 

To eliminate the impact of inflation risk on your investments, you can put your money into schemes such as equity-oriented mutual funds. These funds can provide risk-adjusted returns. However, these schemes also come with certain risks. 

4. Are mutual funds safe investment instruments? 

Yes, mutual funds are largely considered to be safe investment options. However, their performance will be significantly dependent on current market conditions. Similar to any other market-linked investment option, mutual funds will carry certain risks. 

5. What are the two main categories of mutual fund risks? 

Mutual fund risks are broadly categorised into two types: 

• Systematic risk: These are unavoidable risks that are not within your control. Such risks include any government regulation that impacts several asset classes. 
• Unsystematic risk: Risks that impact only a small class of mutual funds are unsystematic risks. These are also called specific risks. 

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Disclaimer: Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.

This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.