Educational

Mutual Funds 101: Types and Risk (Part 1)

Mutual funds are investment strategies that enable you to purchase a collection of stocks, bonds, or other securities that might be hard to recreate on your own. This is often referred to as a portfolio.

Mutual funds words write by a man.

In adition, mutual funds are operated by professional money managers, who distribute the fund’s investment and try to produce capital gains and/or profits for the fund’s investors. A mutual fund’s portfolio is structured and kept to match the investment objectives listed in its list.

See also: The Difference between Stocks and Bonds

Types of Mutual Funds

To illustrate, mutual funds come in different types. Together, you and your financial advisor can find the combinations, quantities, and types of mutual fund shares that are right for you based on your conditions and objectives. Here’s an overview of some of the types of mutual funds.

Money market fund word typed on a paper and pinned to a cork notice board.

Money market funds

In particualr, a money market fund is a type of mutual fund which invests only in highly liquid cash and cash equivalent safeties that have high credit ratings. Money market funds try to limit exposure to losses because of credit, market, and liquidity risks.

Fixed income funds

To illustrate, the fixed income is a type of investment whose return is usually fixed or expectable and is paid at a regular rate like annually, semi-annually, quarterly or monthly. Along with equities, fixed income forms an important part of the investment market and is used for raising capital by the corporations and governments.

EQUITY FUNDS word closed up finger on keyboard.

Equity funds

An equity fund or stock fund is a fund that invests in stocks. Equity funds can be compared with bond funds and money funds. Equity funds can be distinguished by several properties.

Balanced funds

Furthermore, a balanced fund is another option for intermediate-term investors. Balanced funds, which are often called hybrid funds, own both stocks and bonds. They make the “balanced” name by keeping the balance between the two asset classes pretty steady, usually placing about 60% of their assets in stocks and 40% in bonds.

Index funds

An index fund is a mutual fund or exchange-traded fund (ETF) designed to follow certain preset rules so that the fund can track a specified basket of underlying investments. An index fund’s rules of construction clearly identify the type of corporations appropriate for the fund.

See also: The World’s 13 Major Stock Exchanges You Should Know About

Specialty funds

Particularly, specialty funds are a type of mutual fund that focuses their equity investing in an exact business or sector of the economy. Several specialty funds cover wide sectors and others direct their investments on an industry group in a sector.

Sector funds

A sector fund is a fund that invests exclusively in industries that operate in a specific business or sector of the economy. Sector funds are commonly structured as mutual funds or exchange-traded funds (ETFs).

Asset allocation concept graph on blackboard.

Asset allocation funds

An asset allocation fund is a fund that offers investors with an expanded portfolio of investments across various asset classes. The asset allocation of the fund can be fixed or variable among a mix of asset classes. Popular asset categories for asset allocation funds include stocks, bonds, and cash equivalents.

Alternative funds

An alternative investment is an asset that is not one of the conventional investment types, such as stocks, bonds, and cash. Most alternative investment assets are held by institutional investors or credited, high-net-worth individuals due to the complex natures and limited rules of the investments. Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.

Fund-of-funds

A fund of funds (FOF) is an investment strategy of holding a portfolio of other investment funds instead of investing straight in stocks, bonds or other securities. This type of investing is often refers to as multi-manager investment.
Mutual Fund is like an organization which pools the money of investors and invests them on their behalf in a basket of different securities. The basket is divided into units called shares, these can be bought and sold in the market at a price called Net Asset Value (NAV).

These funds are professionally managed. In the current times many emphasis is being put on Mutual Fund investment, and a lot of advertisements have come up promoting it.

However, before investing in it you should have complete knowledge about the pros and cons of Mutual Fund investment and Mutual Funds risk. It no doubt has a lot of advantages and variety but it also has some risks connected with each type, like volatility, liquidity, equity etc.

Types of Mutual Funds Risk

Debt Mutual Funds Risk

In other words, debt mutual fund investments are fixed income tool. It generates monthly profits for the investor. A lump sum (or SIP) amount is deposited into this asset class and it pays interest on that deposited amount to the investor.

Debt funds mean bonds, government bills, treasury bills, commercial papers etc.

Like all other asset classes debt mutual funds also brings certain risk. Mostly, there are two types of risk an investor should be aware before investing in Debt mutual funds.

Interest rates concept.

Interest Rate Risk

This is a very common risk of debt mutual funds. As we know a change in interest rates leads to change in bond price. There is an opposite relationship between bond price and interest rate. Every time interest rate falls, bond price increases and a rise in interest rate decrease the bond price.

The interest rate risk is connected with the variation of interest rate which changes the value of a bond that an investor is holding.

Credit risk word with meaning below.

Credit Risk

It is a risk connected to debt mutual funds which measure the risk of the invested amount to be default. High credit rating instrument will have low chance of credit default risk and instrument with low credit rating will have high chance of credit default risk.

Generally, high credit rating instruments offer lower profits whether low credit rating instruments will offer high profits. Bonds that have high credit risk will do well if the economy performs well similarly, their performance will be affected if the economy fails to perform well.

See also: Tips for high and low risk investment

Balanced Mutual Funds risk

The past two years’ market had been great for the mutual fund investors. Regular market was making new highs and stocks were creating new highs. Balance mutual funds increased a lot of popularity in this period. These funds were suggested for the beginner investors and those investors who are very conservative about investing.

Money Market Mutual Funds risk

The money market is a market which is used to trade financial instruments. Financial instruments with high liquidity and short maturities are traded in the money market.

Participants in this market work as a temporary debtor or creditor. Treasury bills, commercial papers, certificates of deposit etc. are the money market instruments.

Equity Mutual Funds risk

Among all the asset classes like fixed income securities and real estate, equity is considered the riskiest. Without the dividends there is no assurance that it provides. However, risk and expected profit from an investment are directly proportional, and the expected profit from equity is the highest among all. By investing in equity fund, the main advantage an investor gets is that it is professionally managed and can study the equity markets well.

Volatility Risk

Volatility refers to the fluctuations in the share prices. It is a very significant factor that has to be considered while investing in equities. Among equity funds, balanced equity funds are least risky as they attempt to lessen the volatility and fluctuation risk by diversifying the portfolio.

Profits on equity funds generally depend on the conditions of equity stocks in the market. So, if an investor wants to lessen volatility risk he/she must invest in a mutual fund which invests in a diversified portfolio.

Performance Risk

Investors want to invest in mutual funds because it is professionally managed they anticipate its returns to be better than savings schemes like fixed deposits, savings account etc.

However, the returns on equity funds largely depends on the equity market performance and the timing at which the amount is being invested, for example, when the amount is invested at a time when the markets are low at present but will soon be at a bull stage, the returns would be great and vice-versa.

Concentration Risk

Hence, investing in the perfect time is of huge significance. Also, the performance of an equity mutual fund should not always be judged on the basis of latest performance only, as it may be erratic based on the market movement.

In the case of equity mutual funds, it can be very risky if the entire portfolio is very focus toward a single sector or market cap. For example, if the fund only invests in FMCG sector the earnings on the portfolio will exclusively depend on the FMCG sector. In case it performs well the returns will be great and vice-versa.

In order to lessen concentration risk is significant to invest in a fund that diversifies across various sectors or between various markets cover companies. So that if one fails the other will be able to balance it. In a case where a portfolio is not diversified the risk is very high but at the same time, the expected profit is also very high.

Conclusion

The risk is a very key factor that needs to be considered while investing in mutual funds or for any other investment for that matter. There are different types of risks, some can be lessen like systematic risk, and some cannot.

Therefore we should know about the ways to analyze it. Generally, the agreements say that returns are directly connected to risk so, the higher the risk, the higher the returns. It is very essential to know your appropriate risk profile and manage it, by investing in the right mutual fund and the right plan.

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