Is Mutual Fund Safe- Mutual Funds invest in equities or equity-related securities and debt and money market instruments. A mutual fund scheme’s Net Asset Value (NAV) is determined by the market price of the underlying securities in its portfolio. Prices of these securities can fluctuate in response to market activity. As a result, fund literature includes the disclaimer “mutual funds are subject to market Risk.”

Is it Safe to Invest in Mutual Funds?

Investors who have previously invested exclusively in traditional fixed income instruments such as bank fixed deposits, post office small savings schemes, and so on make their first investment in mutual funds frequently have two concerns. (1) How much money will I earn? (2) Is investing in mutual funds a safe bet? Investors must comprehend the following:-

• Mutual funds do not guarantee their investors’ returns.
• Even if a mutual fund scheme pays regular dividends, mutual fund dividends (IDCW) are not guaranteed. The Asset Management Company (AMC) may adjust the compensation (IDCW) payout rate or even suspend dividend payments for some time in response to market conditions.
• Mutual funds do not guarantee capital preservation.

When investing in mutual funds, you should be prepared to take risks. However, suppose you understand the risks and make informed investment decisions based on risk tolerance and financial goals. Mutual funds can provide investment solutions for a broad range of risk tolerances and investment needs. This article will attempt to explain the risks associated with mutual fund investing and address whether mutual funds are safe.

Equity Fund Risks

In in equity mutual funds, there are three types of risks. They are as follows:-

Market Risk

Market risk is also referred to as systematic risk. This is the risk that the stock market as a whole faces. It can be triggered by events that affect the entire economy, such as investment cycles, government policies, and RBI actions, as well as global events such as the COVID-19 pandemic, the Global Financial Crisis, and the 9/11 terrorist attack in New York, among others. Market risk can cause your mutual fund investments to fluctuate.

Specific mutual fund categories, such as midcap funds and small-cap funds, are more volatile than others, such as large-cap funds. You should invest with risk tolerance without regard for the safety of mutual funds.

Unsystematic Risk

This is a risk that is specific to a single stock or sector. While mutual funds seek to diversify unsystematic risk, actively managed funds may still contain some unsystematic risk because fund managers may be overweight/underweight on certain stocks/sectors to outperform the market benchmark index and generate alpha for investors. To avoid systemic risk, you can invest in exchange-traded funds (ETFs) and index funds, which track market indices and are only subject to market risk.

However, investors should understand that unsystematic risk is not always bad because it can help fund managers generate alpha for investors over sufficiently long investment horizons. You should invest according to your risk tolerance and investment objectives, without worrying about whether mutual funds are safe to invest in now.

Liquidity Risk

This can occur due to the fund manager’s inability to sell the scheme’s underlying securities in times of need, such as redemption pressures. If a fund manager cannot sell securities due to market conditions such as extremely high volatility, bear market, etc., the fund manager may be unable to sell the securities. The AMC may suspend redemptions in specific mutual fund schemes during periods of extreme market volatility. Liquidity risk in equity funds is more prevalent in some market segments, such as small-cap funds, than in others, such as large-cap funds.

Risks Associated with Debt Funds

In debt mutual funds, there are three types of risks. They are as follows:-

1. Interest Rate Risk: Interest rate changes affect bond prices. When interest rates fall, bond prices rise and vice versa. Interest rates can fluctuate due to various factors, including RBI actions, increased government borrowing, and currency depreciation. Interest rate risk affects debt funds. Certain types of debt funds, on the other hand, are more susceptible to interest rate risk than others. The longer the duration of a debt fund, the more sensitive it is to changes in interest rates.

You should invest in stock market based on your risk tolerance and investment objectives. If you want to reduce your exposure to interest rate risk, you should invest in shorter-term debt funds without worrying whether a mutual fund is safe.

2. Credit Risk: The credit risk associated with fixed income instruments refers to the issuers’ inability to meet their interest and principal payment obligations, thereby exposing the investor to the risk of income and a capital loss. If the issuer defaults on interest and principal payments, the instrument’s price will be permanently reduced, and the investor may sustain a loss.

Credit risk is the most pernicious risk in terms of fixed-income securities. Is it safe to invest in debt mutual funds? The answer is that you should avoid credit risk by investing in debt mutual funds with a high credit quality rating.

3. Liquidity Risk: Concerns about liquidity lead investors to wonder whether it is safe to invest in mutual funds. This was discussed in terms of equity funds. On the other hand, liquidity risks are relevant to debt funds, as they refer to the fund manager’s inability to sell the scheme’s underlying securities in the event of redemption pressures. Liquidity risk in debt funds is primarily associated with credit risks, specifically with systems that have experienced defaults on underlying debt and money market instruments.

A debt scheme may segregate illiquid assets into a segregated fund and attempt to recoup investors’ money, but recovery timelines may be lengthy. Though this risk typically manifests itself during extreme market volatility, investors should be aware of it and make informed investment decisions.

Other Risks

Sector Risks: Depending on the market conditions, a particular industry sector may outperform or underperform the broader market. While any diversified equity fund that is overweight in specific sectors is subject to sector risk, a mutual fund scheme that invests exclusively in a particular industry, such as sector funds, is subject to greater sector risk.

While a sector fund may outperform a diversified equity fund for some time, it may also underperform if the sector underperforms the broader market for any number of reasons. If you are a risk-averse investor who believes mutual funds are safe, you should avoid sector and thematic funds.

Concentration Risk: The polar opposite of diversification is concentration. Suppose a mutual fund scheme invests a significant portion of its assets in a few securities. In that case, the underperformance of those few guards can have a material effect on the scheme’s performance. Concentration risk is a concern for both equity and debt mutual funds. Concentration risk is primarily relevant for concentrated equity funds compared to diversified equity funds. While total funds have the potential to generate higher alphas, they also carry a higher risk of concentration – you should make investment decisions based on your risk tolerance.

The risk of issuer concentration is also critical for debt funds. SEBI has guidelines on concentration risk about debt funds, but you should also consider a scheme’s concentration risk before investing as an investor.

Currency Risk: This is the risk that changes in foreign exchange rates will impact your scheme’s performance. Currency risk primarily affects international funds and funds with significant foreign securities exposure. It may also affect the returns of gold ETFs and funds. Currency risk can also work in investors’ favor if the Indian Rupee (INR) depreciates against the US Dollar (USD).

Invest by your Risk Profile

Mutual funds offer a diverse range of risk profiles to accommodate investors with varying risk tolerances. Rather than pondering whether it is safe to invest in mutual funds funds at the moment, it would help if you familiarised yourself with the risk profile of a mutual fund scheme to ensure that you are taking the appropriate amount of risk. Equity funds are suitable for investors with a moderate to high tolerance for risk.

Debt funds are appropriate for investors with a low to moderate risk tolerance. There are numerous sub-categories within the broader equity, debt, and hybrid fund categories. SEBI requires mutual funds to label each scheme’s risk profile on Riskometer.

A Riskometer is equipped with six risk levels ranging from low to extremely high. It would help to choose the appropriate risk profile for your risk tolerance. You should consult a financial advisor to determine whether a mutual fund is safe and to obtain assistance in determining your risk tolerance and the scheme’s risk profile in which you wish to invest.