Why Are Mutual Funds Subject to Market Risk?

Whenever you watch mutual fund advertisements on television, at the end, they show a disclaimer that says “Mutual Fund investments are subject to market risks, read all scheme related documents carefully.”
Jul 2022
5 mins read
What does it mean? What are the market risks that mutual funds carry? What are the market risks that are associated with equity and debt funds?

People invest in mutual funds to make profits. But no investment is risk-free. And, although mutual funds provide diversification and value for money to an investor , there are a few risks connected with mutual fund investments. Let's take a look at some of these risks.

What is Market Risk?
Market risk, sometimes also referred to as a systemic risk, is a risk that can result in losses for any investment owing to the market's bad performance. Several elements influence the market, including natural disasters, inflation, recession, political instability, interest rate fluctuations, and so forth. Diversifying one's portfolio will not assist in these situations, but it may be hedged in other ways.

For example, almost every stock lost value in the stock market crashes of 2008 and 2020, even though most firms had done nothing wrong or changed their operations in any way. No single firm could have foreseen or averted the outcome.

Types of Market Risks
Several market risk components may affect various sorts of investments. Equity risk, interest rate risk, credit risk, inflation risk, socio-political risk, and geo-political risk, etc., are the most frequent forms of market risk. The sort of market risk that mutual funds face is determined by the assets allocated in their portfolio.

1. Equity Risk
Equity risk applies to the mutual fund portfolios that invest in stocks/equities of companies. Usually, stocks are volatile in nature and fluctuate on account of various market-related activities. For example, if a major shareholder of the company sells his stake, it may result in a fall in stock price. If your mutual fund invests in that company, your mutual fund portfolio value also decreases due to this event. This is just one example, and there may be several such scenarios that affect equity portfolios. Equity risk also applies to balanced mutual funds that invest in equities.

2. Concentration Risk
Concentrating a significant portion of ones money in any one stock/asset/sector is generally not the most prudent idea. If you are lucky, you can make a good profit, but your losses may also be noticeable at times. Diversifying your portfolio is a practical approach to reducing this risk. Concentrating and significantly investing in a single industry is not wise. The more varied the portfolio, the lower the risk.

3. Interest Rate Risk
Investments in debt instruments, such as government and corporate bonds, are subject to interest rate risk. The Reserve Bank of India controls interest rates. Whenever the Reserve Bank of India raises interest rates, the value of current bonds may fall/decrease. Bond funds, money market funds, and balanced funds are all affected by this sort of risk.

4. Liquidity Risk
The difficulty in redeeming the investments without experiencing a loss in their value is referred to as liquidity risk. This happens when there are no buyers in the market when a seller is trying to sell his/her investments. The lock-in period in mutual funds, such as ELSS, can cause liquidity risk as these mutual funds cannot be sold.
Exchange-traded funds (ETFs) may face liquidity risk. As you may be aware, ETFs, like stocks, may be purchased and traded on stock exchanges. You may be unable to redeem your assets when you need them the most owing to a shortage of purchasers in the market. A way to avoid this is to diversify your portfolio via mutual funds.

5. Credit Risk
Credit risk implies that the scheme's issuer will be unable to pay the promised interest. Rating organisations often assess investment agencies based on these factors. As a result, you will notice that a company with a high rating will pay less interest rate for your deposit compared to a company with lower rating and vice versa. Credit risk also affects mutual funds, particularly debt funds.

In debt funds, the fund manager is required to include only investment-grade assets. However, to achieve better returns, the fund manager may incorporate lesser credit-rated assets. This would raise the portfolio's credit risk. It is important to examine the credit ratings of the portfolio composition before investing in a debt fund.

6. Inflation Risk
In the case of rising inflation, the value of currency erodes gradually over time. Since the returns of money market funds are less, they are the ones that get affected due to inflation. During high inflation periods, investing in stocks is better than investments in money markets.

7. Socio-Political Risk/Country Risk
Events such as war, acts of terrorism, or political elections may have a negative influence on the market. These risks are referred to as socio-political risks. Country risk, on the other hand, refers to the same phenomenon but only when it comes to occurrences that affect investments in other nations.

Mutual funds can be risky because they invest in a wide range of financial assets, including stocks, debt, corporate bonds, government securities, and so on. Because of a variety of circumstances, the price of these instruments fluctuates, potentially resulting in losses as well as gains. As a result, determining the risk profile and investing in the most appropriate fund is critical. It is always better to approach a financial advisor before investing in any asset class.

PGIM India Asset Management Private Limited
(CIN - U74900MH2008FTC187029)
Toll Free Number: 1800 266 7446
Email: care@pgimindia.co.in
This is an Investor Education and Awareness Initiative by PGIM India Mutual Fund.
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The information contained herein is provided by PGIM India Asset Management Private Limited (the AMC) on the basis of publicly available information, internally developed data and other third-party sources believed to be reliable. However, the AMC cannot guarantee the accuracy of such information, assure its completeness, or warrant such information will not be changed. The information contained herein is current as of the date of issuance* (or such earlier date as referenced herein) and is subject to change without notice. The AMC has no obligation to update any or all of such information; nor does the AMC make any express or implied warranties or representations as to its completeness or accuracy. There can be no assurance that any forecast made herein will be actually realized. These materials do not take into account individual investor's objectives, needs or circumstances or the suitability of any securities, financial instruments or investment strategies described herein for particular investor. Hence, each investor is advised to consult his or her own professional investment / tax advisor / consultant for advice in this regard. The information contained herein is provided on the basis of and subject to the explanations, caveats and warnings set out elsewhere herein. The views of the Fund Manager should not be construed as an advice and investors must make their own investment decisions regarding investment/ disinvestment in securities market and/or suitability of the fund based on their specific investment objectives and financial positions and using such independent advisors as they believe necessary.