Updated: Jul 17, 2020
by Rashi Goel
Mutual funds invest in different financial instruments such as equity, debt, corporate bonds, government securities and many more which exposes them to different kinds of risk. Although they are professionally managed, an element of risk remains. The level of risk in a mutual fund depends on what it invests in. Usually, the higher the potential returns of the funds, the higher the risk will be. These risks can be attributed to economic performance, diversification, sector growth and individual company performance.
The most often heard one-liner advertisement is ‘Mutual funds are subject to market risk’. The most basic of all risks is the ‘market risk’. It refers to the losses for any investor due to the poor performance of the market and the only thing a person can do is to wait for the things to fall back in place. ‘The concentration’ forms another reason to risk, it is focusing on a single investment for the entire considerate money. The gains may be huge at times but the losses also pronounce themselves. The best way to avoid these risks is by diversifying the portfolio. The least familiar risk is ‘liquidity risk’. Liquidity risk 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. The risk of the ‘macroeconomics’ forms a major part of the mutual fund's risks and impacts the entire economy. The other risks cover ‘interest rate’ risk and ‘credit risk’ which depends on the credit available with lenders and the demand from borrowers.
The risk is measured based on daily NAV. The measures include alpha, beta, standard deviation and Sharpe’s ratio. ‘Alpha’ gives a measure of the risk-adjusted performance of the investment. Simply put, it gives an idea of the excess returns that the investment fund may generate, compared to its benchmark. ‘Beta’ is fund’s volatility as a regarded market index measuring the extent of co-movement of a fund with that of the benchmark index. Higher values of β indicate a high sensitivity of fund returns against market returns and vice-versa. Higher β values are desired for the mutual funds during the bull phase of the market. ‘Standard deviation’ is a statistical tool that measures the deviation or dispersion of the data from the mean or average. When seen in mutual funds, it tells how much the return from the given mutual fund portfolio is straying from the expected return, based on the fund's historical performance. The ‘Sharpe's ratio’ tells how well the mutual fund portfolio has performed more than the risk-free return. Higher the Sharpe's ratio, better the risk-adjusted return of your mutual fund portfolio.