“Mutual fund investments are subject to market risk” – This is most likely the first introduction to mutual funds for most of us in India. In this article, we will try to give an understanding of the risk in mutual funds investing.
The Oxford English Dictionary defines risk as exposure to the possibility of loss, injury, or other adverse or unwelcome circumstance; a chance or situation involving such a possibility. Anything and everything one does involve risk. Risk occurs when the outcome of any activity is not guaranteed. Risk and investing have more or less been used as synonyms by people. But is risk only present when you are investing money? Clearly, the answer is no.
Risk is a part and parcel of life. Everything you do involves risk but the degree of it varies. Going for a swim involves a risk of drowning. This does not stop people from learning to swim. People believe that they will feel safe in water if know swimming. Risk also differs from person to person. For a 30-year-old investing money somewhere, risk might be losing out on investment money but for a 60-year-old it means losing their livelihood.
Notion of Risk in Investing
To most investors, risk means the possibility of losing money from investments. This is not the same as the definition of risk in mutual funds which we will cover shortly.
Investing in a business can be done in 2 ways – direct investment through shares or loan given for fixed rate of return. Investing directly in a business means participating in profit and losses of the business. These investments are also called Equity investments. Investing by lending money is termed as Debt. Mutual funds also have equity and debt categories. Both these investments are subject to risks explained below.
Business outcomes are uncertain. Predicting movements in prices of raw materials and anticipating competitors actions in difficult. Political announcements can adversely affect the business prospects of a business. The share price of a company reflects the value which the stock market assigns assigns to the company. The share prices fluctuate due to demand and supply of stock, change in global business and socio-economic conditions, launch of new products and services, increase or decrease in profits and so on. This fluctuation in stock prices is called market risk. Market risk is nothing but volatility in returns. Market risk implies that there could be losses in an equity investment for a specific period. The risk of losing money is more prominent in the short term.
Risk in Equity Mutual Funds
Equity Mutual funds carry market risk of stock market fluctuations as they invest in a pool of publicly traded company shares. Hence, they are also subject to market risk or volatility. Since equity funds benefit typically invest in 30 or more shares, they benefit from diversification of risk. Diversification ensures that company specific risks are eliminated and only market risks remain.
In technical terms, market risk can be described as the standard deviation in the returns of a mutual fund. To compare the relative risk of 2 stocks, one could compare the standard deviation in their returns. The higher the standard deviation, the higher risk. A higher standard deviation means that there is higher movement in the stock prices.
But does it mean that any stock or mutual fund with higher risk is bad? No, because we should look at risk weighted returns.
Risk Weighted Returns
Risk weighted returns is a powerful concept in Finance. Every fund manager or investment manager tries to maximize this. In simple terms, risk weighted returns imply that what is the return generated from investments for taking a unit of risk. Sharpe Ratio is a common metric used to measure risk weighted returns of a mutual fund. Comparing Sharpe Ratio of funds is a very good way to compare mutual funds.
Sharpe Ratio = (R – Rf) / Std. Dev
Were R is fund returns, Rf is risk-free interest rate (or govt. bond interest rate) and Std. Dev. is the standard deviation of the fund returns.
Another metric to measure risk-weighted returns is the Sortino Ratio. Similar to Sharpe Ratio, Sortino Ratio is a ratio of fund’s excess returns to the Downside only Std Deviation. Essentially, Sortino Ratio calculation considers only downward movements in fund NAV as Risk. Some analysts prefer Sortino Ratio over the Sharpe Ratio because of this reason.
Risk in Debt Mutual Funds
Debt Mutual Funds invest in a mix of fixed income instruments. These could be government bonds, fixed deposits and bonds issued by banks and other corporates. By definition, fixed income instruments are supposed to generate a rate of return for investors. What could be the risks involved when the returns are fixed? There are two types of risks in debt funds are Credit Risk and Interest Rate Risk.
When a business borrows money, it has the obligation to pay back its lenders first. However, there may be times when business are not performing well and not generating good cash flows. When there is an extreme shortage of funds or cash flows, the company fails to pay its lenders. Failure to pay interest on loans and bonds on time is called defaulting. These default could also be temporary – lasting for a few months before coming back to good shape. This is called the credit risk.
Credit Risk of any bond is measured by credit rating agencies life Moody’s and CRISIL. These agencies give ratings such as AAA, AA, A or B to classify the risk of a bond. AAA is the highest credit rating. These bonds would carry less interest or coupon rate than bonds with AA or A rating. Bonds with a rating in B zone are considered extremely risky and could carry 10% more interest rate than AAA bonds. Debt funds invest in bonds based on their published strategy. Some debt funds have a mandate of investing only in AAA bonds while others invest in A bonds fetching higher returns.
Interest rate risk
Not many investors are aware of interest rate risk applicable in debt funds. Bond prices are inversely related to interest rate of government bonds. When bond rates increase, bond prices fall thus affecting the mark to market valuation of debt funds. The effect of interest rate risk is higher on investment in long term debt funds. Short term, low duration, ultra short term and liquid funds are not affected much by fluctuation in government bond yields.
How to manage risk in investing?
According to Facebook CEO Mark Zuckerberg, “The biggest risk is not taking any risk. In a world that is changing really quickly, the only strategy that is guaranteed to fail is not taking risks.” This precisely captures the essence of risk and reward in investing as well.
Understand your Risk Tolerance
Before investing in any financial instrument, you should be clear of the objective of the investment. Investors in their twenties or early thirties can take substantially more risk than those in their fifties. Also, if you are investing a small percentage of your wealth or income, you could take higher risk with that.
Invest for the Long Term
Investing in equity mutual funds requires a long term horizon. The longer you stay invested in equity funds, the higher are the chances of making good returns and the lesser is the risk of losing money.
It is impossible to time the markets as they are volatile. Investment in equities should be done systematically. Systematic Investment Plans (SIP) and Systematic Transfer Plans (STP) are brilliant tools to reduce market risk from equity investing. Investments done over a period of time help in lowering the averaging cost of equity.
Go for Short Term and High Rated Debt Funds
To reduce interest risk from investing in debt funds, you should stick to short term funds. To reduce credit risk from debt funds, stick to funds which invest in AAA or high rated securities.
Take advise of an investment expert
Sometimes we tend to take a “I know everything” approach to financial investments. While this could for a financial expert, it does not work well for most investors. If you are not an expert in financial markets, then it is better to take expert help in investing. Utilize the services of Financial Advisers / Mutual Fund platforms to guide you through the process of investing and investment management.
If you are looking for expert help on investments, we at Upwardly.in are there to help.