Risk in Mutual Funds: Types, Causes & How to Manage Them

What is the Risk of a Mutual Fund?

At its core, mutual fund risk is the chance that your investment could lose value due to market movements or economic changes. Since funds put your money into stocks, bonds, or money market instruments, their performance is directly tied to those assets.

• Whenever the market value of these underlying holdings changes, the fund’s Net Asset Value (NAV) changes too.
• When the market goes up, the NAV rises, and your investment grows.
• When the market drops, the NAV falls, and the value of your portfolio goes down.

How Market Changes Affect Your NAV

Imagine you put money into an equity fund that holds shares in top listed companies. If the broader stock market takes a hit due to slow economic growth, those share prices fall. Naturally, the fund's NAV drops too, reducing your portfolio value in the short term.

This is why fund houses always mention that mutual funds are subject to market risks. Returns are never guaranteed, and prices will move.

Types of Risk in Mutual Funds

Mutual fund risks usually fall into two big categories: systematic risk and unsystematic risk.

• Systematic Risk: This hits the broader market all at once. Things like inflation, interest rate hikes, or global economic slowdowns affect almost every investment out there. You can't avoid systematic risk through diversification alone.
• Unsystematic Risk: This is specific to a single company, sector, or bond issuer. The good news? You can easily lower this risk by spreading your money across different sectors and asset classes.

Let’s look at the most common individual risks you should know about.

Market Risk

This is the chance of losing money when broad market prices fall. Economic policy updates, global events, and market sentiment cause daily price shifts. Equity funds carry the highest market risk because they track the stock market directly.

Credit Risk

Credit risk mostly applies to debt mutual funds. It is the chance that a borrower (a company or government issuing a bond) fails to pay interest or return the principal amount on time. Debt funds that buy lower-rated bonds carry much higher credit risk than those buying government securities.

Liquidity Risk

Liquidity fund returns happen when a fund manager cannot sell a security quickly at a fair price. If a particular bond or stock has low trading volume and the market panics, the manager might have to sell it at a discount, which hurts the fund's NAV.

Interest Rate Risk

This is another major risk for debt fund investors. Bond prices and interest rates move in opposite directions. When market interest rates go up, existing bond prices drop, pulling down the fund's NAV. When interest rates fall, bond prices go up, boosting the NAV.

Inflation Risk

Inflation risk is the danger that your returns won't keep up with the rising cost of living. Even if your mutual fund makes a 5% gain, high inflation can silently eat away at the actual purchasing power of your profit.

Concentration Risk

Concentration risk happens when a fund places a major percentage of its investment in one industry, company, market, or sector. In the event that such an investment fails to perform well, then the entire portfolio of investments is adversely affected.

Systematic Risk vs Unsystematic Risk in Mutual Funds

Here is a quick look at how these two main categories compare:

How to Measure Risk in Mutual Funds

You do not have to guess how risky a fund is. Fund houses and financial platforms use a few standard numbers to track risk:

1. Standard Deviation

This tells you how much a fund’s returns bounce around its average return over time. Higher standard deviation means higher ups and downs.

2. Beta

The beta of a mutual fund explains the extent of its vulnerability to fluctuations in the market as a whole. Beta greater than one means the fund is volatile and moves in excess of the movement in the market, whereas beta less than one means that the volatility of the fund is relatively lower.

3. Sharpe Ratio

The Sharpe ratio represents the return earned per unit of risk taken. The Sharpe ratio of a fund tells us about the risk-adjusted performance of the mutual fund over a given period of time.

4. Riskometer

The Riskometer is a common measure of risk applicable to mutual funds. The schemes are categorised according to their risk from low to very high.

How to Minimise Risk in Mutual Funds

Risk on mutual funds cannot be eliminated entirely; however, there are several approaches investors could use to manage their risks.

Diversify Your Investments

Making investments in different types of asset class, industries and fund categories makes one less affected by poor performance in any one particular investment.

Invest Using SIPs

Systematic Investment Plan refers to an approach through which investors make investments in regular periods of time. This would enable averaging of costs and making less affected by the ups and downs of the markets.

Choose Mutual Funds Based on Your Risk Appetite

Make sure that you invest in those funds that match your financial goals and investment objectives. If the objective is to make investments in comparatively stable mutual funds, then go for low risk mutual funds.

Make Sure That You Stay Invested for A Longer Period of Time

Longer investment periods might help you cope with the short term risks in markets.

Periodic Review of Your Investments

Regularly review your investments so as to make sure that they are still meeting your financial goals and risk tolerance.

Read the Fund Details

Take a few minutes to read the Scheme Information Document (SID), check the expense ratio, and understand where your money is going before you hit invest.

Conclusion

Every mutual fund is characterised by a varying degree of risk associated with the strategy and portfolio of securities held by it. Knowing about the various types of risks associated with mutual funds, the reasons behind them, and their measurement techniques will go a long way in helping people take a well-informed decision. Though mutual funds are exposed to market risk, using tactics like diversification, systematic investment plans, and the right investment tenure can help reduce the risk to some extent.