Beginners’s Guide To Successfully Manage Mutual Fund Risks

Returns and risks in investments are like a seesaw – when one goes up, the other tends to go down. If you want higher returns, you usually have to take on some level of risk. Investments with potentially higher returns often come with a higher chance of loss.

Let’s take a practical look at this – individuals searching for substantial returns without any risk might be setting themselves up for unrealistic expectations. Claims of risk-free, high returns could be misleading. Generally, higher returns are linked to higher risk. So, if someone tells you that you can earn significant profits without taking any risks, it’s wise to approach it with skepticism.

Take cryptocurrency tales as an example – they often promise massive wealth but may overlook the risks of fraud and the unregulated nature of the industry. Many have unfortunately become victims of schemes like pump and dump in such ventures. Always be cautious and critically evaluate any investment promises that seem too good to be true.

But what are the risks? How do you take countermeasures against these risks? Let’s delve deeper into this article.

WHY SHOULD YOU TAKE RISK?

Let’s break it down with a simple analogy. Think about road accidents – they’re unfortunately quite common these days, with hundreds happening every single day. But does that stop you from hopping into your car and driving to work? Probably not.

Now, draw a parallel to investments. Like navigating the roads, investing requires caution and making wise financial decisions. Just as you don’t avoid driving altogether due to the risk of accidents, you don’t shy away from investing, but you approach it with care and make informed choices. It’s about managing the risks rather than letting them paralyze your financial journey.

Now, let’s talk more about risks. As an investor, we should have the right know-how to deal with risks. Risk mitigation is the most important when it comes to handling investments with higher returns, and why not? – after all, who wouldn’t want higher returns, right? The golden rule again comes into play– “higher the returns, higher the risks.” We cannot alleviate the risks but can only try to mitigate it.

So in this article let us see what the different types of risks our investments could carry along with them and how we go about learning to live with them and negotiate them.

Table Of Contents

1. Types of Risks:
i. Inflation:

• Impact of Inflation and Taxation:

ii. Market Risks
iii. Interest Rate Risk:

• What role does SEBI play here?

iv. Credit Risk
v. Liquidity Risk
vi. Reinvestment Risk
vii. Volatility Risk
viii. Risk of Fraud
2. Why Should You Measure These Risks?

A. Investment Risk Metrics:

i. Standard Deviation:
ii. Beta:
iii. Sharpe Ratio:
iv. Sortino Ratio:
v. Alpha:

B.But do not rely on the ratios only!

C.Misconceived Risks

• Tracking Error
• Expense ratio

3. How to Use These Metrics?

i.Introduction of the Risk-o-Meter (2013):
ii.Revised Risk-o-Meter (2015):
iii.The Trigger for Change – 2020 Franklin Templeton Crisis:
iv.Mandatory Dynamic Risk-o-Meter (From January 2021):
v.Enhancing Transparency and Risk Management:

4.How to Use a Risk-o-meter?

• How does the Mutual Fund Riskometer work?

5. 3 Simple Ways To Curb Risk in Mutual Funds:
Conclusion

1.Types of Risks:

i.Inflation:

Inflation is the rise of prices of goods and commodities over time. It is one of the biggest and most popular risks that come with your investment journey called a “silent killer,” which might get you in deep trouble. To put it simply, if the prices go up, your returns will go down accordingly.

So, inflation is often called the silent underminer because it quietly reduces the value of money over time, affecting an investor’s purchasing power. So, a 5 percent inflation rate over ten years leads to cumulative price increases that erode the value of money.

In order to understand inflation better, you need to know two more things– FD Rate and Real Rate of Return. Fixed Deposit rates typically stay around or slightly above the inflation rate. Whereas the Real Rate of Return considers the effects of inflation, revealing what your money can buy. It reflects the actual purchasing power after factoring in price increases over time.

Impact of Inflation and Taxation

Now consider this: If the return is 6 percent and inflation is 7 percent, the real return is negative, resulting in a loss of purchasing power. And this impact might go unnoticed for a long time– unless you start doing the maths. But that’s not all, we also need to cater to another thing– Taxation.

You need to know that factoring in taxes on interest further affects the actual returns. So, to be profitable above all this, you need to be very cautious while choosing your investment option.

So what does a good investment look like? A good investment ensures that, after taxes, your money maintains its purchasing power against inflation. For instance, while safe options like Fixed Deposits offer security, they might not grow enough to beat inflation. Read the article “How do debt funds score better than Fixed Deposits?” for further clarity.

Schemes like the Public Provident Funds (PPF) consistently provide returns that beat inflation as they fall under the exempt-exempt-exempt (EEE) category. So, as an investor, you can get the tax advantage here– Being tax-free, they form a strong base for the debt part of an investment plan.

ii.Market Risks:

Can you lose money in Mutual Funds?

Market risk, also known as “systematic risk,” is the risk associated with overall market movements. To put it simply, it means the possibility of losing money on investments because the prices of goods and commodities change in a bad way(March 2020, the COVID-19 panic). A good example is when stock or commodity prices go up or down when interest rates change.

Market risks affect all investments to some extent and cannot be fully mitigated through diversification. However, risks that are specific or “unsystematic” can be reduced through diversification. Diversifying investments across different asset classes, industries, and geographic regions helps mitigate the impact of poor performance in any single investment/asset class.

Here’s the most recent breakdown of returns for each asset class as of the end of 2023, reinforcing our assertion that no single asset consistently outperforms others, and the real champion is diversification. It’s a reminder that spreading your investments across different asset classes is a winning strategy.

Courtesy: livemint.com

iii.Interest Rate Risk:

In simple terms, it’s the risk associated with changes in interest rates impacting the value of an investment, particularly fixed-income marketable securities like bonds.

It affects the bond prices. The relationship between interest rates and bond prices is inverse– when interest rates go up, bond prices usually go down, and vice versa. Duration is a huge measure here– it measures how much a bond’s price changes if interest rates change by 1 percentage point. For example, if a bond has a duration of five years, its price might go up by around 5% if interest rates fall by 1%.

The risk here is holding a bond portfolio with an average maturity that doesn’t align with your holding period. Average maturity is the average time it takes for all bonds in a portfolio to mature.

As bonds get closer to maturity, the risk to your principal and interest decreases. Overnight and liquid funds are considered safest because they have shorter maturities.

To prevent mismatching, SEBI has rules tying your holding period to the residual average maturity of the bond portfolio.

• What role does SEBI play here?

SEBI’s regulations ensure that Mutual Funds align their bond portfolio’s maturity with your investment horizon, reducing interest rate risk. It’s essential to match your investment horizon with the right debt fund category to manage interest rate risk effectively. Avoid buying long-term bonds for short-term needs and vice versa. SEBI’s efforts in the late 2010s and early 2020s aimed at cleaning up the debt market further support this risk management approach.

iv. Credit Risk

To understand credit risk better, you need to understand a scenario. Let’s say a borrower borrows some money from a lender. So what if the borrower is unable to repay it because of some reason? You might ask, isn’t this a drawback already? Well, yes, but this only arises when the individual borrows money and may fail to repay it promptly or at all. To compensate for this risk, the lender imposes interest charges.

This compensation is necessitated by the uncertainties related to the potential loss of funds, the waiting period before utilizing the borrowed amount, and the risk of inflation causing a decrease in the money’s value.

The most significant concern for a lender is the possibility of the “borrower vanishing with the borrowed funds.”

In assessing this risk, especially in the context of bonds, credit rating agencies play a crucial role. They assign ratings ranging from very low (such as triple A) to very high (like D minus) to gauge the level of risk.

Government bonds typically entail minimal credit risk, whereas corporate bonds can exhibit a spectrum of quality, influencing interest rates. Investors must comprehend these risks when considering debt funds. Credit-risk funds, while potentially yielding high returns, also pose the risk of underperforming in certain years.

For an investor seeking short-term liquidity through debt funds, avoiding credit risk is crucial. The potential reward isn’t worth the risk of not having the needed funds when required. In simpler terms, prioritizing the safety of our investment and ensuring that you have access to your money when you need it outweighs the potential returns that come with taking on credit risk.

v. Liquidity Risk

Liquidity risk means how easily you can sell something without any hindrance. Think of liquidity risks like trying to sell your house quickly when not many people are buying – you might even have to drop the price. And to many investors, this comes as a huge challenge.

Liquidity is how easily you can turn stuff into cash without losing its value- so if you face problems in doing that, it means that the risk is making it difficult for you to move ahead.

So what can you do in situations like these?

You can simply go for Mutual Fund options. Why? Mutual Funds are safer because they quickly buy back units. So, the liquidity risk here is way less. But with ETFs, there could be a risk if there aren’t many buyers, making prices go down.

vi. Reinvestment Risk

So when does reinvestment risk come into play? Reinvestment risk kicks in when you’re thinking about selling things like successful equity funds, especially when the markets are doing well. The main question is: Where are you going to put the money if you sell? Selling is a good idea if you need cash or want to adjust your portfolio. But if not, keeping onto a winning investment might be smarter, so you don’t risk moving into options that might bring in lower returns.

vii. Volatility Risk

How does Market Volatility affect Mutual Funds? Imagine the financial world as a roller coaster ride. The ups and downs represent the volatility – the risk of prices moving unpredictably, especially over a short period. Now, think of Fixed Deposits (FDs) as a steady train ride on a straight track. FDs have minimal volatility because they don’t trade on the secondary market.

In the bond arena, picture short-term bonds as a calm boat on a lake, gently rocking with the ripples. They have lower volatility compared to longer-term bonds, which may resemble a boat navigating choppier waters.

Now, consider a Bank FD as a serene lake. It’s generally stable, providing a sense of calm. However, the listed stocks of Banking companies are like speedboats on that lake – they can be quite dynamic and volatile.

So, how to mitigate volatility risk in Equity Mutual Funds? Equity is like a hot air balloon. It soars high but is sensitive to various factors – winds of national and international events, as well as company-specific news, can make the ride bumpy.

So whatever the asset, it is always subjected to volatility, just that its magnitude varies. Our focus on managing this roller coaster ride involves figuring out how to measure the ups and downs and finding metrics that guide us through the twists and turns of the portfolios created by Mutual Funds.

viii.Risk of Fraud

I bet you would have heard about so much news like the above example where the company cheated the investors and ran away with the money. You would also have heard about different scams like Sarada chit scams. They have not only duped people to the tune of several hundred crores but also have tarnished the image of the Indian financial industry to some extent. Commoners like us had many concerns when the Mutual Fund industry was at its nascent stage.

But in came SEBI and bought a slew of measures to counter these. The rules governing Mutual Funds were crafted in response to the stock market scam of 1992. These regulations create a robust structure ensuring the safety of investors’ money.

Your money in a Mutual Fund is held by a trust in your name. This means that even if there’s market risk, volatility, or other manageable risks, the structure is designed to prevent the risk of losing your entire invested amount. No sponsor or AMC can run away with your money due to the stringent safeguards in place.

Further, you can read how SEBI is instrumental in safeguarding our interests in one of our earlier articles.

So it is safe to say that the risk of losing your entire invested amount is effectively mitigated.

2. Why Should You Measure These Risks?

Now, out of all the reasons, one of the biggest reasons to measure investment risks is to know what you are dealing with because, no matter what, you are bound to face risks. Achieving high returns with zero risk is unrealistic.

In finance, the goal is to minimize risk for a given level of return. This concept is captured through risk-adjusted returns.

In life, if we are presented with 2 opportunities with the same outcome at the end of a given period, we want to select the one with a smoother passage, isn’t it? The same is the case with Mutual Funds as well. When comparing two funds with the same return, you’d prefer the one that took less risk to achieve it.

Mutual Funds work similarly, and metrics for measuring risk and risk-adjusted returns help investors evaluate and select schemes wisely. You can also read about “How ‘NOT’ to Select a Mutual Fund to Invest.” For a better perspective.

Now let’s see some of the metrics to measure the risk of our investment

• INVESTMENT RISK METRICS:

There are many metrics to measure the magnitude of the investment risks. And with modern expertise in the field, the micro part is going deeper and deeper every single day. These metrics are inclusive of each other– all of them are used in combination to give a better overview.

We will be talking about some of the basic yet important risk metrics.

i. Standard Deviation:

This is the first step in measuring the risk. So, what does standard deviation do? Standard deviation measures how spread out data is from the average. In finance, it helps gauge the risk of returns. A lower standard deviation indicates less risk. For example, if a fund has an average return of 10% with a standard deviation of 2, about 68% of the time, returns will fall between 8% and 12%.

Think of standard deviation in the context of investment risk as the consistency of flavor in a dish.

Let’s take an easy example to break it down. Imagine you regularly order a specific type of pizza from your favorite pizzeria. If the taste of the pizza is consistently close to what you expect each time, it has a low standard deviation. On the other hand, if the taste varies significantly from one order to the next, it has a high standard deviation.

Similarly, in investments, standard deviation measures how much the value of a Mutual Fund’s returns fluctuate from its average return. A Mutual Fund with a low standard deviation suggests more stable and predictable returns, like the consistent taste of your favorite pizza.

Conversely, a fund with a high standard deviation indicates greater variability in returns, resembling the unpredictable taste variations in a dish with diverse flavors.

A higher standard deviation means more variability and potential downside risk (we are okay with the higher upside return as that is what we wanted ). So, when comparing funds, a lower standard deviation, along with other factors like return and cost, suggests a less risky way to achieve a certain return.

ii. Beta:

Beta measures how much a fund’s return deviates from its benchmark. A beta of 1 means the fund mirrors benchmark returns. If the value is less than 1, then it suggests lower volatility, while greater than 1 implies more volatility.

For instance, a beta of 0.80 signifies the fund moves 0.80% on the upper side for a 1% change in the benchmark. We wouldn’t be ok as this is giving us inferior results compared to the index. This is on the upside. On the other hand, if the benchmark index moves down by 1% then your fund may move down by 0.80%, which we are okay with as we lose less when compared to the index.

So in essence, a lower beta indicates less risk.

Check the beta for your actively managed funds. If they are closer to 1 then they effectively give you the index returns only and is better to be in a low-cost passive fund.

So, in active funds, we prefer a lower beta for potential outperformance and not just tracking the benchmark passively.

iii. Sharpe Ratio:

As an investor, we want our scheme to not only beat the index but also to assess whether the return came with too much risk. Here, we can take the help of the Sharpe ratio.

This ratio evaluates the return on an investment compared to its risk. A higher Sharpe ratio suggests that a fund has been able to achieve better returns relative to the level of risk taken. On the other hand, a lower ratio might indicate that the returns are not compensating enough for the investing risks involved in Mutual Funds.

So, when you’re checking out the Sharpe ratio, think of it as a tool that unveils whether the returns you’re seeing are the result of astute fund management or if they might be influenced by taking on too much risk.

iv. Sortino Ratio:

While the Sharpe ratio gives us insights on both “up” and “down” volatility, we want something that tells us about the “downside” volatility without dragging us low. Here, the sortino ratio comes into play.

A high Sortino ratio indicates that the fund achieves excess returns with lower downside risk during market declines. It aligns well with our goal of seeking high returns with less risk (every investor’s dream).

v. Alpha:

To address the excess risk over the general market risk, we turn to a measure called alpha. This assesses the extra return of the scheme compared to the relevant benchmark, considering the amount of risk taken by the scheme.

In simpler terms, it’s a gauge of the fund manager’s actual performance over the benchmark return. Alpha helps you understand if the scheme’s outperformance is a result of the fund manager’s skill in providing higher risk-adjusted return or due to taking on higher risk.

A high alpha indicates that the fund manager is proficient in his / her job, performing well in both up-markets and down-markets. But do not rely on the ratios only!

These ratios help you navigate risks effectively. However, it’s crucial not to rely on ratios in isolation, considering their limitations. Instead, try using multiple metrics at the same time. Using multiple metrics (like standard deviation, beta, and Sharpe ratio) provides a more comprehensive view of informed investment decisions. Having said this, there are also some misconceived Risks that investors should make note of:

C. Misconceived Risks

i. Tracking Error:

Many people have an opinion that Active Funds don’t perform well compared to Index Funds. Is this true? Is the hype of Index Funds real?

Active Funds vs. Passive Funds? Which will Perform Better in the Long Run?

In almost all categories, Active Mutual Funds have performed better than Index Funds. One of the major reasons for this is that alpha is not generated in Index Funds. Because of tracking error and expense ratio, the Index funds will give less return than the Index.

For example In Jan 2023, due to the Heidneberg report, there was a steep fall in stock prices of Adani Group. The actively managed funds stayed away from the Adani Group of stocks because they were doubtful of its valuation. But that is not the case with Index Funds as they have to mimic the index. It took a long time for Index Funds to recover from the impact. Therefore, Active Funds have an advantage over Index Funds.

ii. Expense ratio:

Too much weightage is given to the expense ratio by some investors. Is it necessary?

Mutual Fund returns are Post-Expense Returns and the NAV of a fund that we find is calculated after subtracting the expense ratio. So comparing just the returns of two funds is enough right? If one fund has an expense ratio of 1% and delivers a 15% post-expenses return and the other one has an Expense ratio of 1.5% and delivers a post-expenses return of 18%, then do you think choosing the fund with less expense ratio will make sense?

So why give too much value to the expense ratio and lose out on potential returns?

Additionally, bear in mind that a Mutual Fund with better returns does not necessarily have a lower expense ratio. A good fund is, in reality, one that generates a high return while incurring little cost.

Now that we know why and how to measure investment risks, it’s time to see how you can use this.

3. How to Use These Metrics?

Let’s now put these metrics into use.

The first step is to shortlist the categories we are going to invest in.

Next shortlist the funds within the category, say large cap, Mid cap, etc.

Further, in the shortlisted funds look for schemes with these attributes compare them with the other funds, and choose the best among them:

• Low Standard Deviation
• High Alpha
• Low Beta
• High Sharpe ratio
• High Sortino ratio

Ok, That’s simple.

But there is another simpler way to do this, courtesy of SEBI which introduced us to the RISK-O-METER. Before we delve into how to evaluate the funds based on the RISK-O-METER, let’s see how it has evolved through the years

i. Introduction of the Risk-o-Meter (2013):

SEBI, the regulatory authority, initiated the Risk-o-Meter in 2013 to aid investors in assessing the risk associated with Mutual Fund schemes. The initial version used three colors to compare the risk levels of different Mutual Funds.

• Blue for low-risk (typical of debt funds)
• Yellow for medium risk (typical of hybrid funds)
• Brown for high-risk (equity funds)

However, this version had limitations, lacking granularity in risk assessment within asset classes.

ii. Revised Risk-o-Meter (2015):

In 2015, a revised Risk-o-Meter with five risk levels was introduced. Despite improvements, it failed to capture risk within an asset class and remained static, as determined at the time of the New Fund Offering (NFO). The deficiencies became evident during the 2015 debt fund crisis, notably with JP Morgan Mutual Fund’s impact due to the credit rating downgrade of Amtek Auto.

iii. The trigger for Change – 2020 Franklin Templeton Crisis:

Persisting flaws, highlighted by the 2020 Franklin Templeton debt fund crisis, where liquidity issues led to halted redemptions, prompted SEBI to revamp the Risk-o-Meter. This crisis underscored the need to address risks within an asset class and incorporate bond portfolio quality over time.

iv. Mandatory Dynamic Risk-o-Meter (From January 2021):

The updated version, mandatory from January 2021, introduced significant changes.

• Firstly, the number of risk categories increased to six: low, low to moderate, moderate, moderately high, high, and very high, with overseas funds marked risk level 7.
• Secondly, risk levels were mapped based on the actual portfolio at the NFO, not just the category. Fund houses were mandated to use SEBI-provided formulas for risk assessment in debt portfolios.
• Thirdly, fund houses were required to evaluate portfolio risk monthly, uploading it on the AMFI site.
• Finally, they had to track how often risk metrics changed in a year.

v. Enhancing Transparency and Risk Management:

These changes aimed to provide investors and advisors with a clearer understanding of scheme risks, particularly crucial in debt funds where portfolio quality can significantly change.

A study comparing the old and new Risk-o-Meter during the 2020 Franklin Templeton crisis demonstrated the effectiveness of the updated version.

It offered a more nuanced evaluation, aiding investors in making informed decisions based on the evolving risk profile of their investments. The revamped Risk-o-Meter represents a significant stride towards enhancing transparency and risk management in the Mutual Fund industry.

4. How to Use a Risk-o-meter?

As modern investors deem the risk-o-meter to be a more accurate yardstick for measuring investment risks, it is important to understand how it works.

So, when you’re thinking about putting your money in debt funds, it’s not just about stocks being risky. Debt funds can be tricky too as the underlying bond’s worthiness can change at any time. The Risk-o-Meter is like a tool that helps us figure out how much risk a debt fund carries.

For a safer ride, go for funds with Risk-o-Meter ratings of 1 or 2 – these are like the superheroes of low-risk options. Keep an eye on those ratings regularly because risks can change, like the weather.

SEBI, the superhero regulator, is trying to make debt funds safer. Some investment firms might try sneaky tricks to show off better returns. So, be a smart investor and double-check everything, especially if a fund seems too good to be true.

Also, another important metric in managing risk is to tie up the risk to your holding period. Any asset or fund that you may require within the next 3 years should be under low or a low-moderate indication in the risk –o- meter. While medium-term requirement funds must have been graded low-moderate to moderate in the risk–o–meter, anything more than a 7-year horizon can have a high-risk indication in the risk–o–meter.

• How does the Mutual Fund Riskometer work?

As an investor, we need to think that it’s not only about the returns but it’s also critical that we deal with the associated risks that come with it. While it is not possible to have any product without risk, all we can do is to know the risks and mitigate them through the tools available at our disposal.

5. 3 Simple Ways To Curb Risk in Mutual Funds:

i.Low-Risk Tolerance: This is for beginner investors who don’t want to take much risk and are happy as long as they can make little more than what they invest. This article is an investment guide for investors with a low-risk appetite.“How to invest in Mutual funds without losing a single rupee?.”

ii.Diversification: What is the importance of diversification in Mutual Funds? Diversification stands as the masthead of risk management, spreading the sails of investment across varied asset classes to weather storms and capitalize on fair winds. The below image clearly represents that with diversification you can chase away any bigger risk even though your percentage of allocation is small in size.

iii. Usage of Metrics and Risk –o- Meter: Choosing Mutual Funds based on risk profile is very important. These tools help us navigate the rough seas with ease and figure out the risk profile of the investment.

CONCLUSION

Remember one thing: There is no investment with zero risks. You might hear some investors bluff that certain high-return schemes have no risks. In fact, the truth is higher the returns, the higher the chances of these risks.

It’s high time that we take cognizance of these facts and continue to build a healthy corpus. Please don’t get misled by wrong information on social media platforms like Quora, Facebook, Twitter, etc. Consult a professional financial planner to build a healthy corpus through a comprehensive financial plan.

Happy Investing!