Mutual funds are becoming immensely popular. A major contributing factor is it allows even an investor not familiar with the market dynamics to take a plunge into equity waters. The fund house's research team identifies market opportunities, chalks out a strategy to manage volatility, takes investment decisions and tries to maximise returns.
However, the products that fund houses offer on a platter are diverse and mind-boggling. Balanced funds, diversified equity funds, thematic funds, index funds, gilt funds, income funds, liquid and gold funds, the list goes on and on. It is not necessary for investors to carry all these flavours of funds in their portfolio basket. Every investor has his unique requirements, financial goals, time constraints, liquidity needs and risk tolerance level.
Risks
Investing in stocks, mutual funds and even in debt instruments is not without its risks. The degree of exposure to risk might vary from instrument to instrument and so will the potential returns.
Mutual fund investors repose faith in the investment skills of the fund manager. When the fund's research team and the fund managers fail to perform in line with expectations, investors are exposed to management risk. Change in the fund manager also introduces an element of risk in your portfolio.
If the stock market is faring badly, an investor's portfolio is bound to bear the brunt. Since mutual funds invest in the capital markets, the performance is linked to market turbulence. No amount of diversification or strategy can make the fund immune to market reactions completely.
Mutual fund investors are charged exit loads, even if their fund fares poorly or delivers negative returns, and the investor chooses to exit the fund before the stipulated lock-in period.
Style drift is yet another risk associated with investing in mutual funds. Suppose a person buys a scheme that is predominantly invested in large-cap stocks. Gradually, over a period of a few months the investor realises the scheme is invested in small-cap stocks instead of large-cap stocks. The drift in the investment style over a period of time impacts the investor's risk-return expectation.
Risk tolerance
Risk tolerance is the amount of risk an investor is willing to accept in an investment. There exists an inverse relationship between risk and returns on an investment.
Aggressive investors seek to out-perform the markets and take considerable risk. While their portfolio could be wiped out in bad market conditions, they expect phenomenal profits if the markets head upwards.
A moderate investor carries a mix of both risky and stable asset classes in his portfolio basket. The investor maintains a balance between quest for profits and minimising losses.
A conservative investor is willing to forego significant upside potential in the light of downside market fluctuations. With growth definitely taking a back seat, capital preservation and marginal portfolio appreciation are the main goals of conservative investors.
An investor's risk tolerance changes over time. Younger investors take more risks. They usually do not need the proceeds from their investments immediately and can wait longer for markets to turn around. Older investors are risk-averse and shift their asset allocation from predominantly equity to predominantly debt investments. This is because they need to draw on their investments for their day-today expenses unlike the younger salaried class.
Risk profile and mutual fund picks
Your mutual fund investments must be in line with your risk appetite.
Here are a few pointers:
Beta measure
This is a measure of volatility associated with a particular fund in comparison with the market as a whole. It measures movements relative to the index and gauges the relative risk of a fund. Higher the beta, the more volatile is the fund.
If the beta is one, the fund is exactly as volatile as the market. Its movement is in tandem with the market movement. A beta of less than one indicates the fund's NAV is less volatile than the benchmark index. If the fund's beta is two, it is twice as volatile as the market.
A higher beta indicates the fund is more aggressive than the benchmark.
Standard deviation
It is a statistical measure that is a good indicator of a fund's volatility. It measures the extent these values are dispersed from the average. Standard deviation reflects the consistency of a mutual fund's returns.
A higher standard deviation indicates the NAV of the mutual fund is more volatile, and therefore the fund is risky.
Sharpe ratio
This is a reward-to-volatility ratio. The Sharpe ratio indicates if a portfolio's returns are a result of excess risk. Higher returns with too much additional risk may not be appropriate for moderate and conservative investors. The higher the Sharpe ratio, the better is a fund's returns relative to the amount of risk taken.
