If you are a mutual fund investor then you must’ve read the disclaimer saying, “Mutual Funds are subject to market risk. Please read the document carefully before investing”. You may have heard this line in various marketing ads of mutual fund companies. But, you may not know that this is a regulatory requirement. The thing is many investors equate risk with losses. However, there is only one risky market in mutual funds i.e., Equity Market. Despite, most of us start believing that all mutual fund schemes are risky.
Truth is, not all mutual funds invest in equity. There are debt funds with instruments like Government securities. The reason why equity mutual funds are subject to market risk is that the securities traded in the market and the company’s shares bought and sold through the stock exchanges which are also the part of the capital market.
And the market has ‘Risks’ which known as market risk or systematic risk.
What is the Market Risk?
In general, it is a risk inherent in all types of investments that result from the volatile nature of the market and of the global economy. Market risk is nothing but the possibility the market or economy will decline, affecting individual investments to lose in value regardless of the performance or profitability. For example, the stock market crash of 2008 where nearly all every stock lost value despite the fact that companies didn’t do anything or altered their operations in any way.
Types of Market Risk
There are different types of market risk that apply to different types of investments. Most common are equity risk, interest rate risk, socio-political risk, country risk, and credit risk. The market risk applies to mutual funds depends on the assets held in its portfolio.
Let’s take a look at the different components of market risk.
- Equity Risk: Equity mutual funds are subject to equity risk. It is due to the fluctuation in the prices of the securities in the stock market. This risk can hurt the mutual funds even twice. First, the value of mutual funds can fluctuate, causing shareholder investor to lose value and second, the value of equity entirely depends upon the market value of portfolios solely of stocks. Not just equity mutual funds but balanced funds are also affected by the equity risk.
- Interest Rate Risk: Interest rate risk mostly occurs in the balanced and debt mutual funds. The debt mutual funds which contain debt securities such as Government Bonds and Corporate Bonds. When there is a rise in the interest rate, the bond prices go down, which makes bonds less attractive towards investors. For example, let’s assume an investor decides to invest Rs 10,000 with a rate of 5% for a period of 10 years. In the interest rate changes due to changes in the economy or the RBI increased the interest rate to 7%. In this situation, it will be hard for an investor to sell the bond in the previous 5% interest rate when the new bonds are issuing under a 7% interest rate. This type of market risk seriously affects the bond funds and money market funds.
- Inflation Risk: The investors who are invested in money market funds are mostly affected by inflation It is the risk that gradual inflation will destroy the value of the dollar and reduce the value of long-term mutual fund investments. And the reason it most affected the money market funds is that the returns in money market funds are very low which could easily be outstripped by inflation.
- Socio-Political Risk: It is also known as ‘geopolitical risk’ which is the risk of loss in value of mutual fund investments due to political decisions and disruptions. These political decisions could be about currency valuation, trade tariffs, wage levels, labour laws, environmental regulations, and taxes among others. Political disruptions could also affect the prices of equities including terrorism, riots, coups, international and civil wars and even political elections that may change the ruling government can drastically affect the mutual funds.
- Country Risk: Just like socio-political risk, the country risk also affects the value of mutual funds. However, it only applied to the events that impact investments in foreign countries. This risk could be applied to any of the mutual funds since they impact the US or foreign markets, which in turn affect the equity and debt-based assets within the fund’s portfolio.
- Credit Risk: The credit risk is the type of risk which occurs in the case of an issuer of the scheme who is unable to pay what was promised as interest. This is why many companies and firms have rated by rating agencies on this. In mutual funds, the debt funds are mostly affected by the credit risk.
In a nutshell, we can say that mutual funds certainly have risks which affect the value of investments over time. However, some assets are highly affected by it and some very low. So measuring the performance of all mutual fund schemes on the basis of disclaimer statement: “Mutual Funds are subject to market risk” has no point. In fact, you should give more importance to the capability of a fund manager. It is because the market risk exists in all mutual funds but the question is how a fund manager mitigates these risks without impacting the performance of the scheme. So, the role of the fund manager is extremely critical. No one can completely eliminate the market risk. But, one can lessen it by taking certain measures.
Hope, you find the information useful. If you have any query or would like to add something then doesn’t forget to mention in the comment section below.