There is an inherent risk involved in mutual fund investments. However, an increasing number of people continue to invest in them hoping that their earnings from them would help them beat inflation and ensure financial independence in the long run. The quantum of risk in any mutual fund depends on its underlying securities, which may include equities, bonds and fixed-income instruments. This also explains why mutual funds are mainly classified as equity, debt and hybrid depending on the constituent industry exposure.
Risks in equity mutual funds
More than the asset class risk, mutual fund investors are at the receiving end of both systematic and unsystematic risks.
Systematic risk is associated with market movements. Stock prices go down due to various macro factors, thus, dragging the whole market down. All equity mutual funds and equity-related instruments including balanced advantage and hybrid funds lose their value owing to their heavy asset allocation in stocks. Examples are exchange-traded funds (ETFs) and index funds that are subject to market risks.
Unsystematic risk does not take down all mutual funds at once since it is related to risks associated with a particular stock or sector. This type of risk affects sectoral funds or sector-based indices mostly. The only way to avoid these risks is through adequate diversification. Do not invest in mutual funds catering to one kind of stock only. Do not stick to a particular sector alone. This kind of risk arises when the fund manager is too confident or underconfident about certain stocks or sectors. The weight of those stocks or sectors relative to the market benchmark index is deciding factor behind the quantum of risk suffered. However, this kind of risk is absent in ETFs and index funds and both of them invest in a basket of securities.
Risk indicators in equity funds
Now that you are aware of the kinds of risks involved in mutual funds, it makes sense to learn about certain risk indicators that help us choose the one that we must avoid or keep. Some useful risk indicators include:
Standard Deviation: The standard deviation of a mutual fund scheme's monthly returns from its average return is a measure of its dispersion. It is a measure of the scheme's volatility. The greater the standard deviation, the greater the risk.
Sharpe Ratio: This is much ignored considering how very few investors know about it and realise its importance when choosing a mutual fund among the large number of funds available. The Sharpe Ratio is defined as the excess of average returns over and above the risk-free rate (e.g., T-Bill yield, overnight interbank rate such as MIBOR, etc.) divided by the standard deviation. Sharpe Ratio is a risk-adjusted return metric. The greater the Sharpe Ratio, the greater the risk-adjusted return. This ratio is all about how much returns you can reap with the given quantum of risk.
Beta: How sensitive is your mutual fund concerning market movements? Does the market deplete your mutual fund earnings drastically? These are factors that matter when investing in units of any mutual fund. Essentially speaking, beta measures a mutual fund portfolio's market volatility. While checking the beta of a mutual fund, you learn how your investment would respond to market ups and downs. The market in this context usually refers to the benchmark index that the fund follows. A beta less than one indicates lower volatility, while a beta greater than one indicates greater volatility when compared to the benchmark index.
Alpha: The alpha is the excess return over the market benchmark that has been risk-adjusted. It is the additional return generated by the fund manager as a result of active stock selection. A higher alpha underscores the fund manager’s ability to manoeuvre the working of a fund into earning high returns compared to the benchmark index.
If alpha is equal to 0, it highlights that the fund manager's performance graph is in tune with the benchmark index. However, a negative alpha can be disappointing. Furthermore, a higher alpha in mutual funds over and above 0 demonstrates the fund manager's ability to outperform the benchmark index.
Risks in debt mutual funds
Debt funds usually carry two types of risks.
Interest rate risk is dependent on macro factors as a lot depends on whether the interest rates go up or down. This is because how bonds and non-convertible debentures (NCDs) are priced depends greatly on the market’s interest rates. If interest rates in the market go up, the bond prices will fall. This will result in lower NAVs of the mutual funds investing in these bonds.
Fixed income credit risk refers to the issuers' failure to meet their interest and/or principal payment obligations, exposing the investor to potential income and/or a capital loss. If the issuer fails to make interest and principal payments, the price of the instrument will be permanently written down in the debt scheme's NAV, and the investor may suffer a loss.
Risk indicators in debt funds
These funds contain risks that you may gauge by looking at the following risk indicators.
Length of duration: A long-duration fund will have higher interest rate risk than a short-duration fund, but the longer-duration fund can provide higher returns over long investment tenures because longer-duration fund yields are typically higher than shorter-duration fund yields. The scheme's duration and/or maturity profile can be found in the fund factsheet. You should invest based on your ability to tolerate and how long you can stay invested in the fund.
Credit quality: Credit rating agencies evaluate credit risk and assign credit ratings to debt or money market instruments such as commercial papers (CPs), certificates of deposits (CDs), non-convertible notes (NCDs), and so on. Lower-rated papers will yield higher yields than higher-rated papers, but the credit risk will be higher as well. Credit ratings for debt and money market holdings are disclosed in fund factsheets for individual schemes by asset management companies (AMCs). To make sound investment decisions, you must first understand credit risk.
Using the Riskometer
Mutual fund companies highlight the risks involved with a pictorial depiction of how risky the fund would be. Ranging between “low” and “very high”, a scheme’s ‘Riskometer’ can tell you a lot about what you must expect from the fund’s growth concerning market movements. In Riskometer, schemes are now classified as low to moderate, moderately high, high, and very high risk.
Every asset management company must indicate the risk level of each existing or upcoming scheme. The Riskometer for every product or scheme can be found on the monthly fund factsheets and the fund companies’ sites.
SEBI issued a circular in August 2021 revising the Riskometer to determine risk based on actual underlying securities of a scheme, using market capitalisation, volatility, and liquidity as risk assessment parameters. The Riskometer can help investors understand risk at the scheme level.