Investing in mutual funds isn’t as safe as it looks: 9 risks to be mindful of

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No investment ever completely ensures you will make money or fully preserve your capital. Image Credit: iStock image

Dubai: Like with any other investment, investors are often cautioned beforehand that by investing in a mutual fund, there is no guarantee of any returns or appreciation of the money you put in. But let’s look at why that is.

Often, people are drawn to new investments for the wrong reasons, because they may mistakenly think they can’t lose money, being lured by strong past performance of the investment or fund or are drawn simply by perceived exclusivity of the profitable plan that you sign up for.

The fact is no investment ever completely ensures you will make money or fully preserve your initial investment capital. Still, investors need to explore every avenue for enhancing their return potential and lowering their risk.

Why are mutual fund investments risky?

When it comes to mutual funds, risk arises owing to the reason that mutual funds invest in a variety of financial instruments such as equities, debt, corporate bonds, and government-backed securities (or financial instruments) and many others.

The price of these instruments keep fluctuating due to many factors and with more possibilities of losing money just as much as making a profit, most often if you don’t stay invested you will observe losses accumulating. Hence, it is essential to identify the risk profile and invest in the most appropriate fund.

Due to price fluctuation or volatility, a person’s Net Asset Value comes down, resulting in a loss. (In simple terms, NAV is the market value of all the investment schemes or funds a person has invested in per unit after negating the liabilities.)

How to buy and sell mutual funds
Investors buy mutual fund shares from the fund itself or through a broker for the fund, rather than from other investors.

The price that investors pay for the mutual fund is the fund’s ‘per unit’ Net Asset Value plus any fees charged at the time of purchase.

Mutual fund shares are ‘redeemable’, meaning investors can sell the shares back to the fund at any time. The fund usually must send you the payment within seven days.

Before buying shares in a mutual fund, read the fund’s prospectus carefully. The prospectus contains information about the mutual fund’s investment objectives, risks, performance, and expenses.

Mutual fund shares are ‘redeemable’, meaning investors can sell the shares back to the fund at any time.

How mutual funds are prone to changing market conditions

Any purchase of securities will involve some element of market-related risk. Hence, a mutual fund may be prone to changing market conditions as a result of:

  • Global, regional or national economic developments;
  • Governmental policies or political conditions;
  • Development in regulatory framework, law and legal issues
  • General movements in interest rates;
  • Broad investor sentiment in the investment market; and
  • External shocks like natural disasters and so on

Risk #1: Risk associated with liquidity

Liquidity risk can be defined as the ease with which a security (or financial instrument) can be sold at or near its fair value depending on the volume traded in the market.

(In business, economics or investment, market liquidity is a market’s feature whereby an individual or firm can quickly purchase or sell an asset without causing a drastic change in the asset’s price.)

Liquidity risk also refers to the difficulty to redeem an investment without incurring a loss in the value of the instrument. It can also occur when a seller is unable to find a buyer for the security.

In mutual funds, the lock-in period may result in liquidity risk. Nothing can be done during the lock-in period. In yet another case, exchange-traded funds (ETFs) might suffer from liquidity risk.

As you may know, ETFs can be bought and sold on the stock exchanges like shares. Sometimes due to lack of buyers in the market, you might be unable to redeem your investments when you need them the most. The best way to avoid this is to have a very diverse portfolio and to select the fund diligently.

Risk #2: Inflation-induced risk

Inflation rate risk is the risk of potential loss in the purchasing power of your investment due to a general increase of consumer prices.

(In economics, inflation refers to a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money.)

How do you decipher fees of a mutual fund?
As with any business, running a mutual fund involves costs. Funds pass along these costs to investors by charging fees and expenses. Fees and expenses vary from fund to fund. A fund with high costs must perform better than a low-cost fund to generate the same returns for you.

Even small differences in fees can mean large differences in returns over time. For example, if you invested Dh10,000 in a fund with a 10 per cent annual return, and annual operating expenses of 1.5 per cent, after 20 years you would have roughly Dh49,725.

If you invested in a fund with the same performance and expenses of 0.5 per cent, after 20 years you would end up with Dh60,858. It takes only minutes to use a mutual fund cost calculator to compute how the costs of different mutual funds add up over time and eat into your returns.

If you invested in a fund with the same performance and expenses of 0.5 per cent, after 20 years you would end up with Dh60,858.

Risk #3: Loan financing related risk

If a loan is obtained to finance the purchases of units of any mutual fund, investors will need to understand that borrowing increases the possibility for gains as well as losses.

If the value of the investment falls below a certain level, investors may be asked by the financial institution to reduce the outstanding loan amount to the required level.

The borrowing cost may vary over time depending on the fluctuations in interest rates. The risks of using loan financing in light of investors’ investment objectives, attitude towards risk and financial circumstances should be carefully assessed, investment experts’ flag.

Risk #4: Concentration risk

Concentration generally means focusing on just one thing. Concentrating a considerable amount of a person’s investment in one particular scheme is never a good option.

Profits will be huge if lucky, but the losses will be pronounced at times. The best way to minimise this risk is by diversifying your portfolio.

Concentrating and investing heavily in one particular sector is also risky. The more diverse the portfolio, the lesser the risk of losses is.

Risk #5: Interest rate risk

Interest rate changes depending on the credit available with lenders and the demand from borrowers. They are inversely related to each other. Increase in the interest rates during the investment period may result in a reduction of the price of securities.

For example, let’s say an individual decides to invest Dh100 with a rate of 5 per cent for a fixed number of years. If the interest rate changes for some reason and it becomes 6 per cent, the individual will no longer be able to get back the Dh100 he invested because the rate is fixed.

The only option here is reducing the market value of the bond. If the interest rate reduces to 4 per cent on the other hand, the investor can sell it at a price above the invested amount.

Credit risk means that the issuer of the mutual fund scheme is unable to pay what was promised as interest.

Risk #6: Credit risk

Credit risk means that the issuer of the mutual fund scheme is unable to pay what was promised as interest. Usually, agencies which handle investments are rated by rating agencies on these criteria.

In addition, the following risk factors should also be considered:

How a credit rating downgrade affects a mutual fund’s performance
Mutual fund is rated on the basis of performance of ‘Net Assets Value’, ‘portfolio turnover’, risk and return as well as various expenses like ‘Sharpe ratio’, ‘Beta ratio’ etc.

(As discussed above, Net Assets Value (NAV) is the value of all the securities in a fund divided by the number of individual units, minus the expenses. Portfolio turnover is a measure of how quickly securities in a fund are either bought or sold by the fund’s managers, over a given period of time.)

(Sharpe ratio indicates a high degree of expected return for a relatively low amount of risk. Beta is a measure of the volatility – or systematic risk – of a portfolio compared to the market as a whole.) Due to downgrade in credit rating Net Assets Value (NAV) decreases, hence fund become risky.

So, a person will always see that a firm with a high rating will pay less and vice-versa. Mutual Funds, particularly debt funds, also suffer from credit risk.

In debt funds, the fund manager has to incorporate only investment-grade securities. But sometimes it might happen that to earn higher returns, the fund manager may include lower credit-rated securities.

This would increase the credit risk of the portfolio. Before investing in a debt fund, have a look at the credit ratings of the portfolio composition.

Risk #7: Prepayment risk

This arises when the borrower pays off the loan sooner than the due date. This may result in a change in the yield (return) and tenor (time period) for the mutual fund scheme.

When interest rates decline, borrowers tend to pay off high interest loans with money borrowed at a lower interest rate.

However, there is some prepayment risk even if interest rates rise, such as when an owner pays off a mortgage when the house is sold or an auto loan is paid off when the car is sold.

Since prepayment risk increases when interest rates decline, this also introduces reinvestment risk, which is the risk that the principal amount (invested amount) may only be reinvested at a lower rate.

Risk #8: Lack of control

As much as mutual funds offer the convenience of investing, investors cannot determine the exact composition of a fund’s portfolio, nor can they directly influence which financial instruments the fund manager can buy.

The fund may be diversified enough but the investor has no control over the action taken by the fund manager.

As much as mutual funds offer the convenience of investing, investors cannot determine the exact composition of a fund’s portfolio.

Risk #9: Country risks

It’s the risk due to the changes in the foreign economy where the fund has invested.

Certain statutory changes or economic instability in the foreign country would affect the returns of the fund. This risk mainly affects overseas funds.

Key takeaway: Understanding your portfolio’s risk exposure before investing

Every type of market investment carries some kind of risk. Changes large and small, whether in the specifics of your portfolio or the overall state of the economy, drive market fluctuations can impact your investments.

While mutual funds have many advantages – from the power of pooled investment resources to professional portfolio management – they are subject to the same market and economic forces that all investments face.

Or course, risk is part of any investor’s portfolio. Even if you didn’t invest at all, you’re facing an opportunity risk, which is the risk that you could have grown your wealth more by participating in the markets than sitting on the side lines.

The points above give you an idea of some of the risks involved in mutual funds and how you can mitigate them. Make sure you select the mutual funds prudently.

Most importantly, build a diversified portfolio that not only helps you reach your financial goal but also safeguards you from all the risks.