Are Mutual Funds a safe investment?

When we invest in any Mutual Fund Scheme. The first thing that comes to our mind is whether it is safe? What if the Fund in which we invested runs away with our money? What if that Mutual Fund company or scheme gets involved in some kind of Fraud activities? And lastly, what if it goes Bankrupt?

These questions will pop up in our minds as we are investing a part of our hard-earned income. But you should know that Mutual Fund Companies are regulated by the Securities and Exchange Board of India (SEBI) and the Association of Mutual Funds in India (AMFI). The Mutual Fund Houses are given licenses (they work on licenses just like a bank) after thorough background checks. So, as far as our money is concerned, it will be safe as these regulatory associations keep a close eye on the working of every Mutual Fund Schemes. And even if the Mutual Fund house goes bankrupt, our money would be safely returned to us within a specific time.

Is it safe to invest in Mutual Fund?

To be honest, none of the investments are safe. There is always a component of risk involved. The risk involved can only be lessened but not be fully avoided. You as an investor can only lessen the degree of risk to some extent by doing proper research before putting in your money.

For instance, Even the Fixed Deposits that are considered the safest place to park your funds have risk involved with it. What if the Bank in which you made an FD goes bankrupt tomorrow? What will happen to your money? So, even making a Fixed Deposit is not safe, therefore before making an FD with a bank you need to check that you only make deposits in those banks that are large and well known and whose financials are good to a certain extent.

There are various funds and schemes available to invest in Mutual Funds. Before investing one should know the types of funds available, how one can choose the best scheme for themselves, and the modes through which they can invest in. This will help lessen the risk involved to a certain extent.

Therefore, whether Mutual Funds are safe or not depends on the understanding that you have about a certain fund. And, on how you analyze yourself and select the Funds based on your criteria and the ability to take risks.

Types of risks involved in Mutual Fund

#1 Fund Manager’s Risk

Fund Manager manages the Mutual Fund’s portfolio. It is the Fund Manager who decides what stocks to invest in, when to invest and in what proportion to invest. Now, what if the Fund Manager of the Fund you invested in is not experienced enough? What if the Securities chosen by him fail to perform well in the future? Or, what if he fails to shuffle the portfolio with time according to the situation in the market?

Then that Fund won’t be able to give you the expected returns. This is one of the risks involved when investing in a Mutual Fund. Therefore, one must properly check the background of the Fund Manager of the Fund you are investing in.

#2 Market Risk

Mutual Fund schemes invest in different financial securities. Now, let’s take the example of Equity Funds. As we know, Equity Funds invest in the shares of different companies. Therefore any change in the price of a share of the companies would affect these schemes.

So what if the Market crashes all of a sudden? With the crash in the market the stock prices will also decline sharply, so will the return of Equity Funds. This kind of risk is present when investing in Equity or Hybrid Mutual Fund and is known as Market Risk. Though one should remember that if you are investing for more than 4-5 years then these short-term fluctuations won’t bother your returns so much.

#3 Credit Risk

Credit Risk is generally associated with Debt Mutual Funds. As they invest in Debentures (Company uses them to borrow funds from public and provides fixed return as interest with the principal amount after a pre-decided specific period) of several Companies.

Now, it is also possible that the companies in which the Mutual Fund invested fails to return the amount with interest, and because of which the investors might lose their money. This risk is referred to as Credit risk.

#4 Interest Rate Risk

Interest Rate risk is associated mainly with Gilt Funds. As we know Gilt Funds invest in government securities. These Funds have a very high interest-rate risk. Government securities are like a savings account where you put in your money and earn interest on it. The value of Government securities is inversely proportionate to the interest rate i.e when the interest rate rises the value of Gilt funds falls and vice versa.

How to evaluate the Risk?

It has been made mandatory by the regulatory associations (SEBI and AMFI) that every Mutual Fund should give a risk level to the schemes offered by them through Riskometer. It basically shows that how much risk is the scheme exposed to.

There are 5 risk ratings provided by the riskometer each with different colour. The ratings are as follows:

#1 Low-Risk

A low-risk rating indicates that the particular fund will have the least risk associated with it. These funds would mainly invest in Government back securities which have a zero default risk. It is most suitable for people who are in their old age or for those who are looking for a safer place to invest with fixed returns. And we know that lower the risk so would be the returns.

#2 Moderate Low-Risk

The Funds with a Moderate Low-Risk rating invests the money mostly in Debt instruments like Corporate Debentures, Bonds, Money market instruments, etc, where the risk involved is neither high nor low like Low-Risk rating. The Funds with this rating are most suitable for those people who want to stay invested for a 1-3 year time frame.

#3 Moderate Risk

The Funds with Moderate Risk rating invests a larger proportion of the money in Debt instruments and a very little amount of money in the equity market also, preferably Large-cap Funds. Therefore, with the presence of the equity market, the risk in these funds is also increased to an extent. These Funds are best suitable for a medium to longer time frame. Since the risk is high here so are the returns.

#4 Moderate High-Risk

The Funds that have a moderately higher risk rating involves Equity Funds, Hybrid Funds, Index Funds, and Gold ETF’s. The Funds with this rating are suitable for those investors who can tolerate a higher risk to earn good returns. To get the maximum return you should be invested in these funds for a longer time frame.

#5 High-Risk

The Funds in this category have significant risk involved. Sector Specific Funds, Small-Cap Funds( the mutual fund that invests in the shares of small-cap companies), or Foreign Funds, etc, fall under this category.

Only those investors should be investing in Funds with a High-Risk rating who are in a position to take huge risks to earn great returns and who can stay invested for the long term say more than 5 years.

How to reduce the risk while investing in Mutual Funds?

There are certain points that you should consider when investing in Mutual Funds to reduce the risk:

• If you want to reduce your risk even if the returns that you get are comparatively lower than other high-risk funds. You should be investing only in low or moderately low-risk funds. Since these two categories are less risky than other options available.
• When it comes to investment, Diversification plays a key role. Diversification helps in reducing the risk as all your money is not invested in the same scheme. Therefore, you should be investing in 2-3 different categories of Mutual Fund (like some amount in Low-risk Funds and a part in a Moderately high-risk fund). And also you can keep a certain proportion of your money in other instruments like Insurance or Deposits.
• Investing in Hybrid Funds can also help you lessen your risk to a certain degree as this fund invest both in Debt instruments and Equity Market. So this Fund can safeguard you from fluctuation in the equity market.
• It is said that with age your risk profile should also change. Ideally, when you grow old your investments should shift from high risk to low-risk Funds to protect your capital as well as returns.
• If you are trying to avoid risk then you should stay away from Sectoral funds as well as Mid-Cap and Small-Cap Funds because of their highly Fluctuating nature.

Conclusion

Now, we have understood that there is a part of the risk involved when investing in Mutual Funds which can only be managed and not avoided. Therefore you as an investor should know your investment objective, the amount of risk that you can bear, and the time for which you want to stay invested. Also, before investing it is important to do thorough research about the Mutual Fund Scheme. So, Mutual Funds are a safe investment if the investors have the proper understanding of themselves and about the Scheme.

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