We all have heard the classic disclaimer “Mutual Fund investments are subject to market risks”. Let’s understand these risks. In the financial context different people assess risk differently. For some investors, risk may mean uncertainty, while for some others it may mean an opportunity to grow wealth. And likewise there exist a range of Mutual Fund schemes to cater to varied needs of different category of investors. Let’s look at these types with their relative risk and reward assessments to identify and choose the fund types that suits your risk appetite.
Broadly Mutual funds can be categorised in to Equity funds and Debt funds. Sometimes Hybrid funds are considered a distinct category which aims to combine the benefits of both equity and debt funds.
1. Debt funds: These funds invests in fixed income instruments, such as Corporate and Government Bonds, Government securities, Commercial Papers and Debentures, Bank Certificates of Deposits and Money Market instruments like Treasury Bills etc. These are less volatile, relatively safer investments and are suitable for Income Generation.
Debt Funds are categorized into different types based on the kind of securities they invest in and the maturity (time horizon) of these securities. Overnight Funds – invest in 1-day maturity papers (securities). Liquid Funds – invest in money market instruments maturing within 90 days. Floating Rate Funds – invest in floating rate debt securities. Ultra-Short Duration Funds – invest in debt securities maturing in 3-6 months. Low Duration Fund – invest in securities maturing within 6-12 months. Money Market Funds – invest in money market instruments with maturity up to 1 year. Short Duration Funds – invest in securities 1-3 years maturity. Medium Duration Funds – invest in debt securities with 3-4 years maturity. Medium-to-Long Duration Funds – invest in debt securities with 4-7 years maturity. Long-Duration Funds – invest in long maturity debt (over 7 years). Corporate Bond Funds- invest in corporate bonds. Banking & PSU Funds – invest in debts of banks, PSUs, PFIs. Gilt Funds – invest in Government bonds of varying maturities. Gilt Fund with 10-years Constant Duration – invest in G-secs with 10 year maturity. Dynamic Funds – invest in Debt Funds securities across maturities Credit Risk Funds – invest in corporate bonds below highest ratings.
Debt Funds Risk Assessment: Investing in debt funds carries various types of risk. These risks include Credit risk, Interest rate risk, Inflation risk, reinvestment risk etc. Measurements like ‘modified duration’ and ‘weighted average maturity’ are used to measure the ‘credit risk’ and the ‘interest rate risk’ (the two major risks to be considered before investing). One can find these details in respective fund fact[sheets. If the duration of the fund is high, the volatility of the fund is considered to be high i.e, funds with lower duration are relatively less risky. So, Overnight funds and liquid funds are the least risky funds. Funds with investments in sovereign bonds (Govt. bonds) or corporate bonds of highest ratings (AAA rating) are relatively less risky than funds with bonds below highest ratings. So, credit risk funds, though possibly may give higher returns are relatively more risky.
2. Equity funds: These funds invest predominantly in equities i.e. shares/stocks of companies with the primary objective of wealth creation or capital appreciation and aims to provide the benefit of professional management and diversification to ordinary investors. These can be catagorised as per there investment in Market Capitalisation, the way the funds are managed as well as by the market sectors they invest in.
Based on market cap they are catagorised as Large Cap funds (top 50-100 companies by market capitalisation), Large & mid cap funds, Multi cap funds, Mid Cap funds, Small Cap funds or Micro cap funds. Again, equity funds are either Active or Passive. In an Active Fund, a fund manager scans the market, conducts research on companies, examines performance and looks for the best stocks to invest. In a Passive Fund, the fund manager builds a portfolio that mirrors a popular market index, say Sensex or Nifty Fifty. Also there can be a further classification as Diversified funds, Sectoral funds or Thematic funds. In the former, the scheme invests in stocks across the entire market spectrum, while in the latter it is restricted to only a particular sector or theme like Pharmaceuticals or Infrastructure.
Equity Funds Risk Assessment: Equity funds are more risky than debt funds but have the potential to generate higher return and are best for long term investments. There are measurements like ‘Standard deviation’ and ‘Beta’ that measures the ‘total portfolio risk’ (both systematic & unsystematic risks) and the ‘market risk’ (systematic risk) respectively. One can get these details in respective fund fact-sheets. A mid cap or small cap fund may have the potential to generate higher returns in long run but are more risky compared to large cap, Large & mid cap or multi cap funds. As sectoral funds are highly concentrated, they involve the most risk. Though thematic funds are less concentrated, thus less riskier compared to sector funds, they still are not as diversified as a diversified fund.
3. Hybrid Funds: These funds invest in both Equities and Fixed Income, thus offering the best of both, Growth Potential as well as Income Generation. These funds include – Aggressive Balanced Funds, Conservative Balanced Funds, Pension Plans, Child Plans and Monthly Income Plans, etc.
Hybrid Funds Risk Assessment: Due to the presence of fixed income instruments, these funds are considered less risky than equity funds and due to the presence of equity component, they are capable of generating more returns compared to debt funds.
Now, with gained knowledge of risks and rewards associated with different types of funds, together with the consideration of factors like age of the investor, time horizon of investment, type of financial goal and the importance of achieving that goal etc. one can choose suitable funds that may help him/her achieve future goals effectively.