Equity Mutual funds carry the risk of stock market fluctuations as they are market linked instruments. This is called market risk. The value of its investments decline because of unavoidable risks that affect the entire market.
Even though mutual funds are excellent vehicles of investment for someone who is uninitiated in terms of finance and investing, there are a few disadvantages associated with investing in mutual funds.
It is common knowledge that higher risks promise higher returns. Hence, it becomes essential for you to identify your risk profile and match it with an appropriate fund.
Systematic Risk: This is the risk that is involved with any investment security. It is the risk of the whole financial system being hit. Say, a disaster (natural or man-made) or some other event which negatively influences the public mind-set strikes and the economy goes for a tumble. Stocks crash, indices take a roll and you lose more than what you have invested in the fund. There is little you can do to save yourself against or mitigate such a risk.
Now, let us see about the risk you can safeguard yourself against- the non-systematic risks involved with mutual funds. 1. Interest Rate risk: As Anmol rightly pointed out, funds that have heavily invested in debt and bonds are affected directly by change in interest rates. Equity and index oriented mutual funds are, however, not affected directly by increase or decrease in interest rates.
2. Market risk: It is the risk associated with the volatility of all your investments (stocks, commodities, currency, debt etc..,). A security is said to be more volatile if its price changes a lot over the day in comparison to the others. Volatility can also indicate better returns since there are more chances for us to make money based on these changes in prices. A more passive fund like an index fund is not as much volatile and generally considered a safer investment. The past performance of a fund can tell you how volatile or stable it has been over time. I am sure you would have heard this and tried to repeat it as fast, at least once in your life
“Mutual funds are subject to market risk. Please read the offer document carefully before investing.”
3. Currency risk: When an instrument in the fund is pegged against an international currency, we have to keep tabs on the foreign exchange market too.
4. Liquidity risk: Typically, every investment (other than currency) comes with liquidity risk. It is the risk involved in the ease of getting rid of the instrument. If you don’t have a buyer who is willing to buy your unit of the mutual fund when the market is going down, you can’t do anything about it. It is therefore wise to ensure the mutual fund you are buying is quite an attractive one with bright future prospects.
Understanding the fee structure and avoiding fraud are two other challenges you face while going in for a mutual fund.
Mutual funds claim to invest your money after studying voluminous data sets about security performance, applying various tools of analysis on them and so on. But we don’t have any proof to check the veracity of their claims. They might be as confused as you are. Beware of fraudulent claims and exorbitant returns. Nobody can beat the markets, even if they claim otherwise.
This apart, the other risk of mutual funds is the huge costs (read entry loads, exit loads and asset management charges) involved with mutual funds operation. The complexities involved in mutual fund fees structure is generally beyond the grasp of a common man. Moreover, every transaction of the fund manager results in you having to pay some capital gains tax. Mostly, these costs might give you the wrong idea of your fund underperforming when they are actually eating up your returns.Despite the disadvantages, mutual funds remain to be the best investment option in the market for all types of investors (short term, medium term and long term).