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Benefits and Risks Involved in Investing in Mutual Funds

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Introduction

Nowadays, people are very keen to participate in some sort of investment to help their money grow. This is because they know that money lying dormant is slowly but steadily losing its value. The number one reason for this is the phenomenon of inflation, which is the increase in the price of commodities over some time.

In the current scenario, inflation has been judged to be at an all-time high and will likely keep increasing. This means that if you have a specific corpus saved for the future, in about ten years, that same amount of money will have much lesser value than it does now. How does one counter this?

Some will say let it earn interest in a savings account or a fixed deposit. It may sound like a good idea, but the inflation rate is much higher than banks provide as interest, so you will still lose money. The last remaining resort is an investment. When you invest your money in mutual funds or stocks, the potential to counter inflation is high because the returns are promising. But, as with any other investment, understanding everything about mutual fund risk and return is of utmost importance. But before we weigh the pros and cons of mutual fund investment, let us first understand what a mutual fund means.

What Is a Mutual Fund? 

In the most basic terms, a mutual fund is a collection of money from many investors. Once a significant corpus is generated, it is invested in various types of securities like stocks, debt funds and fixed-income securities. Mutual funds are managed by an Asset Management Company or AMC, which employs professional experts or money managers to handle mutual funds. In the case of stock market investment, you have to buy shares of a company directly via the stock market. On the other hand, in mutual funds, you buy part of a mutual fund, which is invested not only in stocks but also in different portfolios.

When the funds are invested in many different portfolios, the risk of depreciation is low because of the power of diversification. This makes mutual funds one of the low-risk investment options. Also, mutual funds are more beneficial than stocks because it is up to the experts to decide where to invest them based on changing market trends. These money managers' primary goal is to ensure that the investors receive good returns.

Benefits of Mutual Funds 

Mutual funds have steadily become one of the most popular investment options. The reason is simple. This is because investing in mutual funds carries many advantages and benefits, especially when directly compared to stocks. Let us take a look at the many mutual fund benefits below.

 

  • Diversification

 

Regarding mutual funds, diversification means that a single financial instrument does not support the pooled amount of invested money. It is divided and invested in various securities, including equity or shares, debt funds, and money market instruments. The logic behind this is that there is very little chance of all these instruments failing simultaneously.

When one of these fails and gives low returns, others may increase and give higher returns, thus balancing each other out. This ensures that the invested money is much safer, unlike stocks, where you may lose your entire investment because it was put in to buy shares of one company, which is not doing well.

 

  • Professional management

 

Mutual funds are monitored and managed by professional money managers. They are responsible for deciding when and where to invest in the mutual fund by closely following market trends and researching. Investment, whether mutual funds or stocks, is quite an exhaustive process that requires a good understanding of the financial market and great skill.

When it comes to mutual funds, all the hard work is done by these money managers, who are professional experts well-equipped with all the tools required to manage them. Therefore, you can rest assured that your money is in good hands.

 

  • Liquidity

 

The term liquidity means the ability of an asset to be converted into liquid cash. The money in your bank account is purely liquid because you can instantly withdraw it whenever you want. If you have some gold saved, it is still liquid, but it can be converted to cash by selling it quickly. On the other hand, something like your home or your car is not a liquid asset.

When you want to sell it for cash, it could take weeks for the transaction to take place. In this regard, a mutual fund investment is highly liquid, so you can easily convert it to cash when required. Of course, this depends on the type of mutual fund. Enquire about the conditions for selling your mutual fund units before you invest.

 

  • Low capital requirement 

 

Unlike stocks and real estate, which require huge investments to get feasible returns, mutual fund investments can be made with as little as Rs 500. Moreover, there is also the option of Systematic Investment Planning or SIP, which allows you to make small investments monthly for as long as you like. This is one of the most significant advantages of mutual fund investment because people from all strata of society can easily invest according to their capabilities.

 

  • Convenience and simplicity

 

Investing in the stock market can be complicated. Unlike the stock market, mutual fund investment is as simple as possible. You can approach any bank or Non-banking financial company and get your mutual fund investment going instantly. All you will require are some essential Know Your Customer (KYC) documents, and you will be ready.

Risks Associated with Mutual Funds

The risks associated with mutual funds are varied and can be broadly summarised as systematic and unsystematic risks. These risks are natural for the volatile environment of financial markets and can affect the result of investments in many ways. The investor's perspective is that they need to comprehend the risks mentioned above to enable them to make informed investment decisions and manage their portfolios well.

 

  • Volatility Risk

 

Volatility risk is one of the key risks associated with mutual fund investments, especially equity-based ones. They invest in stocks of companies listed on stock exchanges, and the success of these companies influences their valuation. However, the play of this performance is determined by numerous microeconomic factors, such as government policy changes, regulatory directives from SEBI, fluctuations in economic cycles, and RBI policy changes. Factors of such a nature may greatly affect the price of stocks and make the value of mutual fund investments fluctuate. Investors need to be ready for market volatility and have a strategy to deal with periods of increased volatility.

 

  • Liquidity Risk

 

Some mutual funds, like Equity Linked Savings Schemes (ELSS), have a long-term lock-in period, which makes these funds illiquid to investors. In the lock-in phase, it may be difficult for the investors to sell their investments without losing, mainly if there is no buyer in the market. Such low liquidity can limit the investors’ capability of getting the funds when required, showing the need to consider the liquidity requirement before investing in such schemes.

 

  • Interest Rate Risk

 

Another important factor that affects mutual fund investment, in moderation, is interest rate risk, especially in the case of debt funds. This risk arises from the volatility of interest rates, which tends to distort the value of the debt instruments held in the mutual fund portfolio. The price of debt instruments often moves opposite when interest rates change. For instance, a hike in interest rates results in a fall in the price of bonds, leading to a decrease in the mutual fund's overall value. To ensure that the investment returns are not affected, investors should keep track of the changes in interest rates.

 

  • Credit Risk

 

Credit risk is when the issuer of a debt instrument part of a mutual fund portfolio fails to comply with its financial obligations, including payment of interest or repayment of principal amounts. Even though fund managers usually include investment-grade securities with high credit ratings to minimise this risk, investing in lower-rated securities is still achievable to increase returns. Conversely, this approach is associated with higher credit risk because lower-rated securities are more likely to default. This risk can be reduced by properly evaluating the security's credit quality, which is among the information provided in a mutual fund portfolio.

 

  • Inflation Risk

 

Inflation risk is losing value over time due to high inflation rates. This risk is realised when investment returns fail to keep up with inflation. For example, an investment provides a 5% return, and in a country with an inflation rate of 3%, the real return is only 2% after inflation is considered. A way to reduce inflation risk is to allocate the investors’ portfolios to assets that provide returns that are greater than inflation, for example, equities or inflation-protected securities.

 

  • Concentration Risk

 

Concentration risk sets in when investors direct a large part of their funds to one investment or sector, thereby risking potential losses if the investment underperforms or the sector undergoes unfavourable market conditions. A stock investment in a single company is an excellent example of how the investor suffers from concentration risk with his fortunes tied so closely to the performance of that company. Asset allocation between different asset classes, sectors, and geographies can help minimise concentration risk and improve portfolio robustness.

 

  • Currency Risk

 

Currency risk results from volatility in exchange rates, a significant factor for investments in a foreign currency. Currency exchange rates may affect the returns investors obtain from converting their foreign currency investments to their domestic currency. Hedge strategies or investments in mutual funds that hedge currency exposure can minimise currency risk, which reduces the effect of exchange rate fluctuations on investment returns.

 

  • Rebalancing Risk

 

The rebalancing risk is the disadvantage of fund managers' active portfolio rebalancing. Rebalancing must ensure that the portfolio remains aligned with the investment objectives and risk tolerance, but it can also lead to missed growth or excessive transaction expenses. Investors should evaluate the rebalancing practices of mutual funds and sense the trade-offs of portfolio rearrangement against costs of management or lost opportunities.

Risk Management Measures 

Those were all the risks. Let us now look at a few risk management techniques to help investors overcome a few risks. 

 

  • Portfolio Diversification

 

Diversification refers to the distribution of investments among asset classes, sectors, and regions, thus reducing the chance of a negative market impact on the whole portfolio. Using equities, bonds, cash equivalents, and alternative investments in asset diversification allows investors the flexibility to control risk and attain prospective returns.

 

  • Risk-Adjusted Portfolio Construction

 

It is vital that the portfolio development is consistent with the investors’ needs, risk tolerance, financial objectives and investment horizon. Examples are represented by the investors who use a balanced portfolio of equities and fixed-income securities and have low-risk tolerance for long-term financial goals, combining risk and return for capital growth and income generation with a level of safety.

 

  • Systematic Investment Planning (SIP)

 

Investment in mutual funds using Systematic Investment Plan (SIP) by the way allows investors to invest a specific sum of money in a mutual fund over time thereby empowering the investors to invest regardless of the fluctuation in market prices. This prudential budgeting prevents the organisation from being affected by the minimum investment cost and can neutralise losses due to market volatility.

 

  • Asset Allocation Strategies

 

This is an anticipated result to achieve optimal risk-adjusted returns representatives of strategic asset allocation driven by fluctuating market conditions and economic analysis. Consumers may choose to increase their weight to consumer staples and real estate sectors during macroeconomic uncertainty, whereby they defend their portfolio from losses.

 

  • Ongoing Review and Monitoring

 

Mutual funds should be reviewed and appraised regularly to confirm that the investments align with the investment objectives and risk tolerance. Rebalancing through portfolio revisits and changes in market requirements are essential in keeping your portfolio in performance and risk control.

In conclusion, mutual funds are a peculiarly attractive means of accumulating wealth; however, they carry certain risks that should be considered. This knowledge, through risk management strategies, helps the investors to effectively deal with the complexities of the market and succeed in the long run.

Below is a table that lists risks & their mitigation techniques: 

Types of Risks

Mitigation Tip

Volatility Risk

Selecting a diversified portfolio comprising funds schemes with low to moderate risks will help tackle market volatility.

Credit risk

Invest in high credit-rated securities with a track of paying substantial and timely interest.

Liquidity risk

Investing in a diversified portfolio that comprises funds schemes with moderate to high liquidity will be helpful—for instance, liquidity funds.

Concentrated risk

Instead of investing in one asset class or investment sector, investors can put their money into diverse asset classes and sectors.

Inflation risk

Parking money into schemes like stock mutual funds, which extend risk-adjusted returns, will help combat inflationary effects.

Riskometer 

Risk-o-meter tells you the risk level of a mutual fund and helps you make better investment decisions by comparing it with other funds that fall under the same category.

As you can see, the risk levels of mutual funds are categorised as Low, Low to Moderate, Moderate, Moderately High, High, and Very High.

These risk grades are assessed based on a mutual fund's underlying securities. Put simply, it depends on what kind of stocks or bonds are owned by that particular mutual fund.

Are there any limitations? Well, yes. Most equity funds have been assigned a standard 'Very High' risk without considering the fund's essential characteristics, which can mislead you.

For instance, a small-cap fund is far more risky than a passive large-cap fund, but the risk-o-meter fails to capture the difference in risk levels.

However, the risk-o-meter is relevant for debt funds because its criteria are well-equipped to highlight the risk signals in a debt fund's portfolio.

The risk-o-meter is updated every month. Ever since mutual fund houses were asked to disclose the risk-o-meter every month, investors have been receiving frequent emails with updates, if any.

However, this may not necessarily mean any big shift in the fund's strategy; therefore, you should be reassured about the risk-o-meter notifications.

You should be cautious if you notice a significant change in your fund's risk-o-meter.

Where Can You Find Mutual Fund Risk-related Details on Angel One?

To find details on a mutual fund’s risk:

  1. Open your Angel One app and go to the Mutual Fund section.
  2. Choose the mutual fund whose details you want to view.
  3. Click on the fund name once more, and you will find the detailed fund page.
  4. Scroll down to ‘Risk and Ratings’ where you will get all the risk-related information.

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