How Safe Are Your Mutual Funds |
Posted: June 15, 2017 |
How safe are your mutual funds? Every mutual fund advertisement comes with a disclaimer “Mutual funds are subject to market risk, please read the offer document carefully before investing”. More than anything else this has been one of the key reasons why many investors are put off with the idea of investing in market-linked options. However that’s definitely not the entire story, because as they say, “the devil is in the details” and knowing the details of the risks associated with investing in mutual funds, it is necessary for any prospective investor in order to make an educated decision. In fact, the KIM documents released by fund houses ranging from Franklin Templeton Mutual Fund AMC to Mahindra Mutual Fund AMC have quite a few pages dedicated to the concept of risk with respect to their funds. Additionally, they also provide details regarding how they would attempt to mitigate and minimise these risks. The problem though is that these documents make for very boring reads and most investors are unable to understand the implications. In the following sections, we will discuss some common risks associated with investing in mutual funds. Risk to Principal Invested This risk is applicable to each and every type of mutual fund, but most commonly associated with equity mutual fund options. Funds are market-related investment options, therefore, market movements in either direction would influence the performance of the fund. Thus if there is a substantial downward correction in the market, your investment value may decrease significantly in the long term. This is the basic form of risk to the principal invested. However, it is important to note here that historic records show that markets have always inched upwards subsequent to a correction no matter how radical/significant. In fact, most of the times, an investor makes a loss when he/she panics witnessing a falling market and redeems/switches his/her investment instead of holding the units when the markets witness a downward movement. Liquidity Risk Mutual fund investments are definitely a lot more liquid than fixed deposits where substantial penalties are applied if withdrawn prematurely. However, in extraordinary cases, the mutual fund management team may decide to delay redemption of the scheme’s investments and this can cause quite a bit of liquidity risk when a huge number of redemption requests may be received during tumultuous market conditions. However, this risk is more prominent in the case of equity investments as they have only a small amount of cash/debt/call or other money market investments that can be liquidated in a hurry. Debt mutual funds such as liquid funds, short-term debt funds, etc. are a lot more liquid and less prone to this risk. ELSS tax saver funds like Franklin Templeton Mutual Fund AMC’s Taxshield are among the most illiquid investments available to an investor as they have a lock-in of 3 years with no option of a premature withdrawal. Sector-specific Investment Risks A few mutual funds are termed as sectoral funds as they have a high degree of exposure to a specific sector. For example, Franklin Templeton Mutual Fund AMC’s Infrastructure Fund invests up to 90% of its capital in companies engaged in infrastructure development/growth activities ranging from road making and shipping to construction and ports management. In case there is a downturn in the sector, the value of any investments made into the fund would be significantly decreased. This is the crux of the sectoral risk that may be present in case of a mutual fund investment. Most mutual fund management teams manage this risk by diversifying their investments in a sector-agnostic fashion, which is not possible in case of a thematic mutual fund. Default Risk This risk is specific to debt mutual funds that primarily invest in the company bonds. The value of these funds increases when the company services its debt in a timely manner. However, there is always the risk that a company will no longer be able to service their debt and default on the bond. In this case, the debt fund will witness a loss and this situation is the basis of default risk in case of mutual fund investments.
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