Measure your mutual fund's risk, before it becomes too late
Understanding Mutual Fund Risks: A Comprehensive Guide to Assessing and Mitigating Investment Risks for Optimal Returns and Financial Security.
When investments are tied to equities, they are often perceived as riskier assets. Equity mutual funds are consistently viewed as risky, and there are methods and terminologies used to quantify the risk of funds. Focusing solely on returns while disregarding risks can be perilous for one's investment portfolio.
In this world, every activity carries some degree of risk; some even argue that doing nothing is a significant risk in life. Mutual Funds stand out as one of the most popular investment avenues due to their diversified nature, convenience, and professional management by qualified fund managers. However, the phrase "mutual funds are subject to market risk" often resonates in our minds, as mutual funds are diversified across various assets such as equities, bonds, funds, real estate, commodities, and derivatives, exposing them to different risks. Let’s explore the various types of risks associated with Mutual Funds:
- Market Risk – Market Risk is a systematic risk that affects every security due to poor performance of the benchmark and the economy. Factors contributing to these risks include geopolitical tensions, global crises, inflation, recession, interest rate fluctuations, and natural calamities, among others.
- Liquidity Risk – Liquidity risk refers to the possibility of being unable to sell or redeem an investment due to a lack of liquidity. This risk often arises from changes in interest rates, currency rates, etc. Small-Cap funds and ETFs are particularly susceptible to this risk in bear market conditions.
- Interest Rate Risk – Interest rates reflect the credit availability in the market. This risk affects Debt Funds more significantly since debt funds and interest rates are inversely proportional. Therefore, when interest rates rise, debt funds tend to decline, and vice versa. Investors in debt funds must consider this risk while investing.
- Credit Risk - Fixed income securities (debt and money market securities) are subject to the risk of an issuer’s inability to meet interest and principal payments on its debt obligations. The Investment Manager endeavors to manage credit risk through in-house credit analysis, but for higher returns, fund managers may invest in assets with low credit scores. Credit funds are exposed to this risk.
- Inflation Risk - Inflation, or price inflation, refers to the general rise in the prices of various commodities, products, and services. Inflation erodes the purchasing power of money, and failure to account for inflation may result in investors falling short of their goals.
- Country and Currency Risk – This risk arises from uncertainty regarding a country's economic and political conditions. Additionally, changes in currency rates affect investment values. Fluctuations in domestic and foreign currencies result in fluctuations in the gap between the two currencies.
Methods to Measure Risks in Mutual Funds:
- Standard Deviation – This measure indicates the total risk of the mutual fund and signifies the volatility of mutual fund returns. For example, if a scheme has a standard deviation of 4 per cent and an average return of 12 per cent, it implies that the scheme can provide returns ranging between 8 per cent to 16 per cent.
- Sharpe Ratio – The Sharpe ratio measures risk-adjusted performance by considering standard deviation. It is calculated by dividing the excess returns earned by the fund over the risk-free rate, aiding investors in understanding risk and making informed decisions.
- Sortino Ratio – Similar to the Sharpe ratio, the Sortino ratio focuses on downside deviation only, as upside deviation is beneficial for investors. A higher Sortino ratio indicates a lower probability of downside deviation for the fund.
- Alpha – Alpha represents the excess returns earned by the fund over the benchmark, reflecting the skill of the fund manager and their sector allocation proficiency. A higher alpha indicates better returns.
- Beta – Beta measures the volatility associated with a benchmark or market, indicating how the fund behaves relative to market movements. A beta greater than 1 signifies higher volatility than the market, while a beta lower than 1 suggests lower volatility.
- R-Squared – This statistical measure reflects the fund's movement concerning a benchmark index. An R-squared between 0.75 to 1 indicates a high correlation with the benchmark, providing a better understanding of risk when evaluated alongside beta. A higher R-squared indicates a more useful beta variable.
- Yield to Maturity - Yield to maturity is the anticipated rate of return, mostly annualized, that an investor can expect if they hold the bond until maturity. Similarly, for a fund manager holding bonds in the mutual fund portfolio, the yield to maturity reflects the expected returns. Ideally, a fund's yield to maturity should match or slightly be lower than the category's yield to maturity.
- Modified Duration - Modified duration measures how much a fund's price changes due to fluctuations in its yield to maturity. For instance, if a fund's modified duration is three years and the market interest rate decreases by 1 per cent, the fund's price would increase by 3 per cent, and vice versa. Investors seeking to minimize interest rate risk should opt for funds with lower modified duration.
In essence, investment risk refers to the possibility that the actual return on an investment will be lower than expected. Investors often concentrate solely on past returns without considering associated risks. The level of risk associated with investment trusts varies from scheme to scheme, and the success of such investments depends on the alignment of returns with associated risks. Therefore, investors must understand these risks, interpret risk parameters correctly, and identify their risk profile to select the best fund for optimizing returns.
Disclaimer: The article is for informational purposes only and not investment advice.