Educational

Mutual Fund Risk: Basics and Tips (Part 2)

Mutual fund is an investment instrument, basically collection of stocks and/or bonds, managed by professionals of an asset management business. Investors will put their money in different types of mutual fund units depending on their risk appetite and period of investment.

MUTUAL FUNDS word on Chalkboard with Coffee Cup.

Mutual funds have become a very popular option for an extensive variety of investors. This is primarily because of the automatic diversification they offer, as well as the advantages of professional management, liquidity and customizability.

See also: Mutual Funds 101: Types and Risk (Part 1)

Basics of Mutual Fund

NAV (Net asset value), business/finance conceptual.

Net Asset Value or NAV

NAV is the total asset value (net of expenses) for every unit of the fund and is calculated by the AMC at the end of every business day.

How is NAV calculated?

The value of all the securities in the portfolio in calculated every day. From this, all expenses are deducted and the resultant value divided by the number of units in the fund’s NAV.

Expense Ratio

AMCs charge an annual fee, or expense ratio that covers governmental expenses, salaries, advertising expenses, brokerage fee, etc. A 1.5% expenses ratio means the AMC charges Rs100 in assets under management.

A fund’s expense ratio is typically to the size of the funds under administration and not to the returns earned. Usually, the prices of running a fund grow slower than the growth in the fund size – hence, the more assets in the fund, the lower should be its expense ratio.

Load

Some AMCs have sales charges, or loads, on their funds (entry load and/or exit load) to pay for distribution expenses. Funds that can be bought without a sales charge are called no-load funds.

 

Open-and Close-Ended Funds

Open-Ended Funds

When in the scheme period, investors can enter and exit the fund scheme (by buying/ selling fund units) at its NAV (net of any load charge). Gradually, AMCs are issuing mostly open-ended funds.

Close-Ended

Redemption can take place only after the period of the scheme is over. However, close-ended funds are listed on the stock exchanges and investors can buy/ sell units in the secondary market (there is no load).

Important documents

Two important documents that highlight the fund’s strategy and performance are the prospectus or the legal document and the shareholder reports or the normally quarterly.

Mutual Fund Risk

Risks of closed-end Mutual Funds

Closed-ended funds are actively managed Mutual Funds that raise a precise amount by Initial Public Offering (IPO), after which no one can invest directly into them (they are traded like stocks in a listed exchange). They usually focus on one trade, geographic market, or sector. Every Mutual fund has its own management and manager, objectives, and strategy; therefore any two funds may have important variations in their risks, price volatility, and fees.

Liquidity Risk with the financial data visible in the background.

Liquidity Risk

In case of closed-ended Mutual Funds, when it invests in equity, investing for long-term offers a better chance of great returns. However, if we invest in for longer time frame liquidity becomes a problem. Since close ended mutual funds are actively managed it’ll work once the stocks have sufficient liquidity. While being listed there’s no guarantee that the stocks will be liquid and thus funds need be very careful while choosing the stocks. Also, in case of close-ended mutual funds, an investor can redeem their units solely at the maturity date but can sell it through the exchange if needed.

Risk-Free Mutual Funds

The risk involved in investing in a mutual fund completely depends on the underlying asset the mutual fund is investing or aiming to invest in, investment objective etc. There are various mutual funds which invest in different asset classes with different levels of risk.

For example, a fund which invests in fixed income securities like bonds, etc. will be somewhat safer than the ones investing in the equity market (shares). A kind of risk-free mutual fund can be Arbitrage Mutual Funds. This fund takes the advantage of price differences, but from one market and invests in the other, so they are nearly risk-free or have a very minimum amount of risk involved. Short term Mutual Funds are also relatively less risky.

The risk in Mutual Fund SIP

Systematic Investment Plan (SIP) in an investment plan where an investor can make expenses in a scheme systematically every month (or a pre-defined time period). Generally, returns in SIP mostly depend on the investment outlook. That is the time frame from which you hold the strategy, typically higher the time frame is compensated with higher returns. But with a higher time frame, liquidity is suffered. Another mutual fund risk is the credit risk or the default risk in case of instruments like bonds. One major mutual fund risk involved in investment through SIP is fund manager performance risk.

Fund Manager Risk

The performance of a fund mostly depends on the fund manager’s ability to manage and balance risk. Fund manager risk is the risk connected with manager fund not being able to perform up to the expectations of the investors. This risk is mostly prevalent in the funds which are actively managed, for example, closed-ended Mutual funds.

Measurement of Mutual Funds risk

There are various measures of risk that can be used to analyze an investment.

ALPHA word with Colorful alphabet blocks spelling.

Alpha

This measures the risk in relation to the market or any specific index.

Beta 

Beta is a measure of volatility or systematic risk. This can be lessened with the help of diversification.

Standard Deviation

This is a measure which measures the returns from the mean value or mean returns over the years.

Sharpe Ratio

It is a measure of excess return per unit of risk taken.

These are some measures that can be used in order to analyze the returns of the mutual fund or any other investment.

Mutual funds are an excellent way to diversify your investments.

Rather than buying shares in a handful of blue chip companies, for instance, you can buy a mutual fund that owns hundreds of stocks.

Mutual Fund Tips

Make sure you’re diversified.

Why is diversification significant? It wouldn’t be necessary if the market always preferred blue chip stocks or small-cap corporations or Treasury bonds.  No one, however, can predict which assets will be on top each year or even each quarter.

For many people, a basic, diversified fund portfolio includes these four asset classes: the Large-cap stocks, Small-cap stocks, International stocks, and Bonds.

How you diversify with these and other asset classes will depend on a variety of factors. Here are some questions to ask yourself:

What are my investment goals?

What is my time outlook for each of these goals?

How much risk am I comfortable with?

How are my investments allocated now?

Don’t be tempted by recent results.

Some investors buy funds based on short-term performance, which is never a good idea.

Finally, how you fare as an investor greatly depends on the mix of stock and bond funds that you have. If you own too many similar funds, your portfolio assumes too much risk.  A lot of individual investors don’t realize that they own lopsided portfolios.

Look at the big picture.

Resist the temptation to look at your holdings through a pinhole. For example, the object is not to diversify just your 401(k) among the funds accessible in your office. You need to look at all your holdings, including a 401(k), IRAs and taxable accounts.

By doing this, you can cover holes in your portfolio. Suppose, for example, that your 401(k) menu does not offer a small-cap fund, you can pay for this omission by investing in one of these funds in an IRA or some other account.

Be mindful of expenses.

Be sure to check a fund’s expenses because they can have a huge effect on a fund’s performance. In many cases, the funds charging the lowest fees are also the ones sporting the best returns because low fees give funds a huge built-in advantage. This is why 95% of all flows over the past years have gone into funds in the lowest-cost quintile. Index funds have profited excessively from this trend.

You can decide how much your fund is charging you by looking at its expense ratio, which refers to the percentage of your investment that is automatically taken out of your fund assets to pay for fees.

Conclusion

A mutual fund brings together a big group of people and invests their totaled money in stocks, bonds, and other securities. There are many, many types of mutual funds. You can classify funds based on asset class, investing strategy, region, etc.

Some funds carry not any broker fee, known as no-load mutual funds. One of the major problems with mutual funds is their costs and fees. Mutual funds are easy to buy and sell. You can either buy them straight from the fund corporation or through a third party.

Comparing fund returns across numerous metrics is significant, such as over time, compared to its benchmark, and compared to other funds in its peer group.

HQBroker is here to give you a daily news roundup about the forex, commodities, technologies, automobiles, and economies. You can open an account now and make yourself updated with essential news in the market. Share your thoughts and experiences with us by commenting your HQBroker reviews.

Leave a Reply