MF investment & its risks

Are you aware of your fund's risks?

'Mutual fund investments are subject to market risks. Please read the offer document carefully before investing.' How many times have you heard this? Probably several hundreds of times. But have you ever got down to reading the offer document to know the kind of perils the scheme is exposed to? Mutual funds invest in a range of securities, each having its own risk profile. The fund manager's skills play an important role in balancing these risks. However, there are certain threats that are beyond his control. These are known as market risks. Sameer Bhardwaj lists some of the risks and the ways in which they could impact your investments.
Equity funds
These funds invest predominantly in shares across sectors and market capitalisations and keep a small portion in cash and debt. They are prone to the following risks:
Macro-economic risk: Stock prices are sensitive to economic developments. Changes in interest rates, currency exchange rate, inflation and taxation, as well as those in government and central bank policies, tend to influence the prices of equities. A rise in the inflation rate can lead to an increase in equity risk premiums that could depress the equity markets. A weakening currency also dampens the equity markets.
Liquidity risk: How liquid are the stocks in your mutual fund portfolio? Any constriction in trading volumes of these stocks could affect the fund manager's ability to transact. This, in turn, could significantly affect the fund's NAV. The funds that invest in small-cap or unlisted stocks are more prone to liquidity risks than the funds with index-based stocks. The drop in demand for these securities could lead to losses for the scheme.
Non-diversification risk: A fund aims at eliminating or minimising internal (company-specific) risks through diversification. However, at times, a particular sector or segment of the capital market may take up a sizeable proportion in the fund's total assets, thereby exposing the fund to the risk of non-diversification. For example, if mid-cap stocks account for a big chunk of a fund's corpus, the fund could be at substantial risk if the markets turn bearish. This is because mid-cap stocks bear the brunt when the market declines.
Corporate performance risk: Fund managers look for undervalued companies with strong fundamentals that are likely to show improved operational performance over time. However, companies may not perform as per the investor's expectations owing to an increase in their costs or a drop in revenue. This could hit the fund's NAV as the stocks get hammered.
Equity mutual funds that invest in overseas securities are subject to the following risks:
Currency risk: If a fund invests a proportion of its corpus in stocks whose prices are denominated in foreign currencies, it is exposed to the exchange rate risk. The distribution of income and, correspondingly, the value of a fund are adversely affected by changes in the value of a foreign currency relative to the Indian rupee.
Country and political risk: Any deterioration of political relations between two or more countries can also pose risks for the fund manager. Immobilisation of overseas financial assets and introduction of extraordinary exchange controls are just two examples of such threats. Such risks also include a country's inability to meet its financial obligations, which could adversely affect the value of a mutual fund.
Debt funds
These funds invest in debt instruments issued by governments, private companies, banks, financial institutions, utilities, and in money market instruments. They face the following risks:
Credit risk: Also known as default risk, this arises due to the inability of the issuer of debt instrument to pay periodic interest or repay the principal on maturity. You can assess the credit worthiness of the issuer by considering the ratings assigned by rating agencies. A fall in the credit ratings leads to a fall in the price of the debt instrument in the secondary market, and this significantly impacts a fund's NAV.
Interest rate risk: The prices of debt securities, especially bonds, are extremely sensitive to the movement in interest rates. The price of a bond falls as the interest rate rises, and vice versa. Let's assume that a substantial portion of the corpus of a fund is invested in bonds with a coupon rate of 10 per cent, which are purchased by the fund manager at a face value of Rs 1,000. The price of these bonds will go down to Rs 833.33 if the interest rate goes up to 12 per cent. This will affect the fund's NAV negatively.
Reinvestment risk: This emanates from the probability that the periodic cash flow from bonds will be reinvested at a rate lower than the coupon rate of the bond. This reduces the cumulative interest component of the bond, which reduces the value of the fund. Consider a fund that has invested in a 10 per cent coupon bond and which pays a half-yearly interest. The purchase price of the bond is Rs 10,000 and its term is five years. If periodic interest payments are reinvested when interest rates have fallen to 8 per cent, the cumulative interest component will plunge. This will hit the fund's NAV.
Marketability risk: The secondary market for debt is not fully developed in India. Trading is concentrated in very few securities. Moreover, trading volumes vary on a daily basis. This exposes debt mutual funds to marketability risk. While transacting in debt securities, funds are exposed to a substantial impact cost (measured by using bid price and offer price), which affects the NAV of a fund.