7 Most Common Types of Mutual Funds and their Risks

Mutual funds risk is very common, like any other investments. You could gain or lose money on your investment in the process. The value of most mutual funds will change as the value of their investments goes up and down.

The level of risk in a mutual fund depends on what it invests in. Usually, the higher the potential returns, the higher the risk will be. For example, stocks are generally riskier than bonds, so an equity fund is likely riskier than a fixed income fund.

Some specialty mutual funds focus on certain kinds of investments, such as emerging markets, to earn a higher return. These kinds of funds also tend to have a greater risk of a larger drop in value.

This article will talk about common types of mutual funds as well as its types of risks.

7 Common types of Mutual Funds

7 types of Mutual Funds Infographic

Money Market Funds

These funds invest short-term fixed income securities. Those include government bonds, treasury bills, bankers’ acceptances, commercial paper and certificates of deposit. They are a safer investment, but with a lower potential return then other types of mutual funds.

Basically, this is a safe place to keep your money. You won’t get substantial returns, but you won’t have to worry about losing your principal. A typical return is a little more than the amount you would earn in a regular checking or savings account. It is also a little less than the average certificate of deposit (CD).

Fixed Income Funds

These funds buy investments that pay a fixed rate of return like government bonds, investment-grade corporate bonds and high-yield corporate bonds.

They aim to have money coming into the fund on a regular basis, mostly through interest that the fund earns. High-yield corporate bond funds are generally riskier than funds that hold government and investment-grade bonds.

Equity Funds

These funds invest in stocks. These funds aim to grow faster than money market or fixed income funds. Thus, there is usually a higher risk that you could lose money.

You can choose from different types of equity funds. Those includes that specialize in growth stocks, income funds, value stocks, large-cap stocks, mid-cap stocks, small-cap stocks, or combinations of these.

Balanced Funds

These funds invest in a mix of equities and fixed income securities. They try to balance the aim of achieving higher returns against the risk of losing money.

Most of these funds follow a formula to split money among the different types of investments. They tend to have more risk than fixed income funds, but less risk than pure equity funds. Aggressive funds hold more equities and fewer bonds, while conservative funds hold fewer equities relative to bonds.

Because there are many different types of bonds, bond funds can vary dramatically depending on where they invest. For example, a fund specializing in high-yield junk bonds is much more risky than a fund that invests in government securities.

Index Funds

These funds aim to track the performance of a specific index. The value of the mutual fund will go up or down as the index goes up or down.

Index funds typically have lower costs than actively managed mutual funds. That’s because the portfolio manager doesn’t have to do as much research or make as many investment decisions.

Specialty Funds

These funds focus on specialized mandates such as real estate, commodities or socially responsible investing. These types of mutual funds forgo broad diversification to concentrate on a certain segment of the economy or a strategy.

Global/International Funds

These funds invest only in assets located outside your home country. Also, they can invest anywhere around the world, including within your home country.

It’s tough to classify these funds as either riskier or safer than domestic investments. But they’ve tended to be more volatile and have unique country and political risks.

On the other hand, they can, as part of a well-balanced portfolio, actually reduce risk. That is by increasing diversification since the returns in foreign countries may be uncorrelated with returns at home.

Mutual funds eyeglass

7 common types of mutual funds risk

Business Risk

This risk refers to the possibility that an issuer of a stock or a bond is going to go through a loss and/or go bankrupt. Also, in the case of a bond, it will be unable to pay the interest or principal repayment.

Business risk can be influenced by many factors. Those factors include competition, government regulations, the economy and more. Mutual funds hold securities of many different companies, which minimize this risk.

Market Risk

Basically, market risk is a risk which may result in losses for any investor due to a poor performance of the market. There are a lot of factors which affect the market. A few examples are a natural disaster, inflation, recession, political unrest, fluctuation of interest rates.

Market risk is also a systematic risk. Diversifying a person’s portfolio won’t help in these scenarios. The only thing which the investor can do is to wait for the storm to calm.

Credit Risk

Credit risk actually refers to the possibility the issuer of a bond will be unable to make timely principal and interest payments. Usually, agencies which handle investments are rated by rating agencies on these criteria. 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. Thus, this would increase the credit risk of the portfolio.

Interest Rate Risk

Interest rate risk refers to the possibility interest rates will rise and reduce the value of your investment. Fixed rate instruments decline in value when interest rates rise.

Longer-term fixed-income securities such as bonds and preferred stocks have the greatest amount of interest rate risk, while shorter-term securities such as Treasury bills and money markets are affected less. Thus, an increase in the interest rates during the investment period may reduce the price of securities.

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.

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 making fund selection diligently.

Inflation Risk

Inflation risk refers to the possibility that the value of an asset or income will decline as inflation shrinks the value of a country’s currency.

Because inflation can cause the purchasing power of cash to decline, investors may want to consider investments that appreciate. That includes growth stocks or bonds designed to stay ahead of inflation long-term.

Concentration Risk

Generally, concentration means focusing on one thing. Concentrating a huge amount of a person’s investment in one particular scheme is not a good option.

Profits will be huge if lucky, but losses will be more. Best way to minimize this risk is by diversifying your portfolio. Concentrating and investing heavily in one sector is also very risky. The more diverse the portfolio, the lesser the risk is.

Why is mutual funds investing risky?

Risk occurs in mutual funds owing to the reason that mutual funds invest in a variety of financial instruments. That includes equities, debt, corporate bonds, government securities and many more. Additionally, the price of these instruments keeps fluctuating owing to a lot of factors like supply-demand, change in interest rate, inflation, etc.

Due to price fluctuation or volatility, a person’s net asset value comes down ending in a loss. Basically, NAV is the market value of all the schemes a person’s invested in per unit after negating the liabilities. Thus, it becomes essential to identify the risk profile and invest in the most appropriate fund.

Mutual funds solving

Assessing risk

Assessing the risk is crucial especially in mutual funds. One way to assess a fund’s level of risk is to look at how much its returns change from year to year. If the fund’s returns are substantial, it may be considered higher risk because its performance can change quickly in either direction.

How your mutual funds investment is protected?

Because mutual funds are securities – and not deposits – they’re not under protection of Canada Deposit Insurance Corporation (CDIC) or other deposit insurance.

However, investors are protected by other safeguards; First, a third-party custodian holds the assets of a mutual fund; and second, an independent auditor reviews and reports on the fund’s financial statements each year.

Bottom Line

Before you invest, understand the fund’s investment goals and make sure you are comfortable with the level of risk. Even if two funds are of the same type, their risk and return characteristics may not be identical.

The level of risk in a mutual fund depends on what it invests in. Usually, the higher the potential returns, the higher the risk will be. Therefore, minimize your overall risk by holding a variety of investments. Before you decide on a mutual fund, figure out how it fits with the rest of the investments you own.

See Also: 5 of the Best Types of Bonds You Should Know in 2018

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