Understanding Mutual Fund Risks: A Comprehensive Guide for Investors in India

by Alina Khan

Published On Nov. 10, 2023

In this article

Investing in mutual funds has gained significant popularity in India due to their potential for generating returns and diversifying portfolios. While mutual funds offer numerous benefits, it's essential for investors to understand that they are not entirely risk-free. In this comprehensive guide, we will delve into the various risks associated with mutual funds. Understanding these risks is crucial for making informed investment decisions and managing your investment portfolio effectively.

1. Market Risk:

Market risk, also known as systematic risk or market volatility, is one of the primary risks associated with mutual funds. It stems from fluctuations in the financial markets, such as stock and bond markets, which can impact the overall value of a mutual fund. In India, market risk is particularly relevant due to the dynamic nature of the country's stock markets.

Example: In 2020, the COVID-19 pandemic caused a sharp decline in Indian stock markets, leading to significant losses in equity mutual funds. Investors who were not prepared for such a market downturn experienced a decline in the value of their investments.

2. Credit Risk:

Credit risk pertains to the possibility of bond issuers defaulting on their interest payments or principal repayments. Debt mutual funds, which invest primarily in bonds, are exposed to credit risk. In India, credit risk is especially pertinent as the quality of corporate bonds can vary significantly.

Example: If a debt mutual fund holds bonds of a company that defaults on its interest payments or goes bankrupt, it can lead to a decrease in the fund's Net Asset Value (NAV) , causing losses for investors.

3. Interest Rate Risk:

Interest rate risk is relevant to debt mutual funds, which are sensitive to changes in interest rates. When interest rates rise, the value of existing bonds with lower coupon rates may fall, impacting the NAV of debt funds.

Example: If the Reserve Bank of India (RBI) decides to increase interest rates to combat inflation, debt mutual funds holding long-term bonds may experience a decline in NAV.

4. Inflation Risk:

Inflation risk, also known as purchasing power risk, occurs when the returns on your investments do not outpace the rate of inflation. In India, inflation has historically been a significant concern, and it erodes the real value of your investments over time.

Example: If you invest in a mutual fund that provides a return of 6% while inflation is running at 7%, your purchasing power effectively decreases.

5. Liquidity Risk:

Liquidity risk is associated with the ease of buying or selling assets in a fund. While open-end mutual funds in India generally offer high liquidity, certain categories, such as closed-end funds or thematic funds, may have limited liquidity.

Example: Closed-end funds, which have a fixed number of units and may not be as actively traded, can experience liquidity issues, making it challenging to sell units quickly.

6. Managerial Risk:

Managerial risk refers to the risk associated with the competency and decision-making of the fund manager. An ineffective or inexperienced manager may make poor investment choices, leading to suboptimal returns or losses.

Example: If a fund manager consistently makes poor investment decisions, it can negatively impact the fund's performance and erode investors' wealth over time.

7. Regulatory Risk:

Regulatory risk arises from changes in government policies and regulations that can affect mutual funds. Indian financial markets are subject to regulatory changes that can impact the tax treatment, expense ratios, or investment options available to mutual fund investors.

Example: The taxation of equity mutual funds in India underwent changes in 2018, impacting the holding period for long-term capital gains tax exemption. Investors need to stay informed about such regulatory changes that can affect their investments.

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8. Sectoral and Concentration Risk:

Some mutual funds may focus on specific sectors or industries, leading to sectoral risk. If the chosen sector faces challenges, the fund's performance may suffer. Concentration risk occurs when a fund holds a limited number of securities, exposing investors to the risk associated with those holdings.

Example: A mutual fund exclusively invested in the technology sector could experience significant losses if the technology sector faces a downturn.

9. Exit Load Risk:

Exit load is a fee charged to investors who redeem their units within a specified time frame. Exiting a mutual fund before the applicable exit load period can result in lower returns for investors.

Example: If an investor decides to redeem their units of a mutual fund within the exit load period, they may incur a penalty that reduces their overall returns.

10. Market Timing Risk:

Market timing risk occurs when investors try to time the market by entering or exiting mutual funds based on their predictions of market movements. This strategy can be risky, as market timing is notoriously difficult to execute successfully.

Example: An investor who tries to time the market may miss out on potential gains during market upswings or incur losses during market downturns.

11. Currency Risk (for International Funds):

Investing in international mutual funds exposes investors to currency risk. Fluctuations in exchange rates can impact the returns of these funds when converted back to the Indian rupee.

Example: If an Indian investor holds units of an international mutual fund and the foreign currency depreciates against the rupee, it can lead to lower returns when the investment is repatriated.

12. Geopolitical Risk (for Global Funds):

Global mutual funds invest in international markets, making them susceptible to geopolitical events and international conflicts that can impact the global economy.

Example: Geopolitical tensions between countries can lead to market volatility, affecting the performance of global mutual funds.

Managing Mutual Fund Risks:

While mutual funds do carry risks, there are strategies investors can employ to manage and mitigate these risks:

  • Diversification: Invest in a variety of mutual funds across asset classes to spread risk and get the benefits of diversification

  • Risk Assessment: Understand your risk tolerance and choose mutual funds that align with your risk profile.

  • Long-Term Perspective: Maintain a long-term investment horizon to ride out market volatility and reduce the impact of short-term risks.

  • Regular Monitoring: Keep track of your investments and stay informed about market developments and fund performance.

  • Consult a Financial Advisor: Seek professional advice to make informed investment decisions based on your financial goals and risk tolerance.

To learn more about diversification, read our detailed article: Diversification in Mutual Funds: Building a Resilient Investment Portfolio

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Wrapping Up

Mutual funds offer a range of investment opportunities in India, but they are not without their share of risks. Investors must be aware of these risks and take steps to manage them effectively. By diversifying their portfolios , assessing their risk tolerance, and staying informed about market conditions, investors can harness the potential of mutual funds while minimizing the impact of associated risks. Remember that investing always carries some degree of risk, and understanding these risks is a vital part of becoming a successful and responsible investor.

Read these articles to understand all about mutual funds and how you can invest in mutual funds with Wright Research:

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  4. What is Standard Deviation in Mutual Fund and How Does it Help in Portfolio Management?

  5. Find Out What Portfolio Risk Is & How to Reduce It

  6. Smallcase vs Mutual Fund: Understand Difference and Similarities

  7. SIP Investment Guide: What is SIP, How to Start, Benefits, & Is It Worth It

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