Mutual funds refer to a pool of resources collected from investors, which is later invested in equity and debt securities to generate returns. Returns from investment in these securities is quite sensitive to market fluctuations. Therefore, it is advisable to measure one’s risk appetite and financial objectives before investing in mutual funds.
To talk about the safety of investing in mutual funds, one should be aware of their subjectivity to market risks. However, they are tightly regulated, transparent, liquid and highly diversified in nature.
How are Mutual Funds safe?
1. Regulatory Oversight
The Securities and Exchange Board of India (SEBI) exercises close oversight over mutual funds.
- Mutual Funds are governed by a Scheme Information Document (SID) which is filed with SEBI and must be approved by the regulator.
- SEBI lays down a maximum exposure limit to ownership of individual stocks.
- SEBI category rules set minimum and maximum limits for exposures to individual assets (such as equity or debt) within a fund.
While investing in a Mutual Fund, it is important for the investor to go through all the scheme related documents carefully. To ensure safety, SEBI has laid down certain rules for AMCs to comply to:
- The valuation of a mutual fund, termed as NAV or the Net Asset Value is declared on each business day.
- Mutual Fund investors have been enabled to know the performance of their investment at any given point of time.
- Mutual Funds also publish their investment portfolios at the end of each month. Investors can thus observe the allocations made by individual funds at various intervals.
Diversification is one of the most critical factors while making investments. It makes mutual funds a lot safe compared to direct equity investment in few stocks or putting all the savings in a single piece of land.
- Mutual Funds hold diversified portfolios, wherein a typical equity fund (excluding sector funds) will hold 20-40 stocks.
- A Mutual Fund cannot invest more than 10% of its assets in a single stock.
- Hybrid Funds, a type of Mutual Funds invest in both equity and debt, thereby further diversifying your risk.
One of the major benefits of investing in Mutual Funds is their liquidity. Most Mutual Funds are open-ended in nature, implying that one may redeem his/her investment on any business day.
- In some cases, you may have to pay a small fee called an Exit Load if you pull out your money too early.
- Your ability to access your own money in the form of Mutual Fund investments is not hampered directly.
- The liquidity conditions, however, are quite different while investing in land or insurance, where pulling your money out is extremely difficult.
What is the Risk Involved?
Although the above mentioned reasons clearly state that Mutual Funds are relatively safe, they are still subject to market risks.To know more about the nature and extent of risk involved and how you may avoid it, read below.
- Fund Manager Risk
The fund manager may not be able to outperform the market. As a result your fund may give you low or even negative returns. To avoid this, you may choose to invest your funds with an organization that has an impressive investment portfolio.
- Market Risk
The market as a whole may go down sharply. If this happens, your Equity Mutual Funds or Hybrid Mutual Funds will also go down in value. There may also be times when the entire market may get overvalued, such as in the late 1990s during the dot com boom and in 2007-08 before the financial crisis.
- Credit Risk
Debt Mutual Funds invest in the bonds and debentures of different companies. These companies may default on these borrowings. To mitigate this risk, mutual funds usually buy highly rated bonds.
- Interest Rate Risk
The value of bonds usually falls when the interest rates rise. In such a scenario (as happened in 2018), your mutual funds, which hold bonds, can also lose value.
How to Mitigate the Risk in Mutual Funds?
As they say, “Prevention is better than cure”, it is advised that the risks involved in Mutual Fund investments are mitigated well in time. Below are a few thumb rules to be followed-
- If your investing horizon is less than 3 years, stick to debt funds only. Within the debt category you can go for liquid funds or corporate bond funds (the latter can only hold AAA rated debt). This will keep your credit risk and interest rate risk contained.
- If you are investing for more than 3 years, pick a fund category that best suits your risk appetite. Hybrid Funds which mix equity and debt carry a moderate level of risk, large cap equity funds carry a moderate-to-high level of risk and sectoral funds carry an extremely high level of risk.
- SIPs or Systematic Investment Plans allow investments of a fixed sum in a mutual fund scheme at predetermined intervals. These investments reduce the potential financial risk associated with the lump sum investment, enabling the investor to make adjustments in his investments, moving in line with the current financial situation of the investor.