Why only MF investments are subject to market risks?

Why only MF investments are subject to market risks?


Many investors equate risk with losses. Many individuals believe that all mutual fund schemes invest money in shares. In reality, not all schemes invest in shares. And not other investments are free of risks.


“Mutual fund investments are subject to market risks. Please read the offer document carefully before investing.” – These lines are part of any marketing communication by any mutual fund company. This is a regulatory requirement. This line has the potential to strengthen a major myth. Since mutual fund investments are subject to market risk and there is only one risky market (equity market), all mutual funds are considered to be investing in equity. 

This is a misconception about mutual funds. The reality is: Not all mutual funds invest in equity. 

There is another issue with this line – It has the potential to scare an investor – the word “risk” has a negative connotation. Many equate “risk” with “losses”. 

The third issue is: the word “risk” is strongly associated with all mutual funds. 

Whereas it is a good idea to talk about risks while investing, picking up only one product and sparing the others has the potential to lead the investors to believe that only those products are risky where one talks about risk. Any other product where the word “risk” is not mentioned is assumed to be risk-free. 

Let us understand that unlike most other products, mutual fund is a pass-through vehicle, in which all the investment risks are passed on to the investor since the investor is the owner of the fund. This is not the case when one invests in say a fixed deposit. Let us take the case of a company fixed deposit. An investor is promised a certain return on investment in such fixed deposits. What the company does with the money thus collected determines the return the company earns – in most cases, the company raise money through this route for their investment in the business or their working capital requirements. The company is supposed to pay the investor only the promised return – nothing more, nothing less. If the company is unable to earn more than what it has promised the depositors, there is a risk that the promise may not be honored. This is known as credit risk for the depositors. 

This risk does not exist in case of a mutual fund, since the ownership of the fund is with the fund’s investors. However, the fund may be subject to this risk as the investments made by the fund may default on their commitments. Is it possible to manage some of the risks? Is it possible to avoid some? Well, diversification is a proven strategy that can be used as protection against credit risk. 

A diversified mutual fund, as the name suggests, automatically offers diversification. However, the one risk that a mutual fund portfolio cannot do anything about is the risk of marketwide price fluctuations. If the fund invests in a market where prices fluctuate a lot, the NAV of the fund is likely to witness huge fluctuations (e.g. growth funds investing in equity market); however, if it invests in a market where prices do not fluctuate, the NAV of the fund would be quite stable (e.g. liquid funds investing in money market). When we talk about price fluctuations, it is important to separate the market price fluctuation from that in the price of individual securities. There are certain factors that impact the broader market and prices of most securities fluctuate at the same time – this is called market price fluctuation; whereas some factors only impact individual securities, resulting into fluctuation in the price of an individual security. 

Diversification can help reduce the latter, but cannot reduce the former. As can be seen from the above discussion, it is not the mutual fund that carries the risk, but the underlying investments where the mutual fund has invested. Mutual funds simply pass on some of the risks and reduce some others. It might be proper to say: “all investments are subject to certain risks. 

Please understand the risks before investing.” Do not get scared by the risks in investing. These are as normal as day and night or the various seasons. Understand and manage the risks to get the most out of your investments


Happy Investing

Source : Moneycontrol.com

Article By : Amit Trivedi
Karmayog Knowledge Academy