We all agree with the slogan ‘Mutual funds sahi hai.’ There are many reasons why mutual funds are an attractive investment option. However, we need to remember that they come with a tagline warning investors about the risks involved.
You must be educating your clients on the traditional investment risks such as market risk, credit risk, interest rate risks and so on. However, there are some other risks associated with MFs which are equally important. Let’s have a look at them.
Liquidity risk is the inability to sell your investment in market due to lack of demand. Generally, mutual funds pride themselves on providing easy liquidity to investors. However, there are certain exceptions to this rule. Earlier, in case of stressed debt markets because of a security’s credit default, some fund houses had to temporarily suspend redemptions.
Another scenario where liquidity risk comes into play is closed end schemes. Despite the schemes being listed on stock exchange investors may find it difficult to redeem their investments before maturity. This happens because the demand for close ended funds is low in secondary market. Post SEBI regulation, there will not be many close-ended schemes.
Country risk refers to risk involved in investing in a country (apart from home country). You need to evaluate this risk because any major political or economic instability in the said country has the potential to seriously dent your client’s investments.
This risk comes to play when you recommend foreign funds to your clients. As nature of the country risk differs from country to country, you need to evaluate the likely economic, business and political risks faced by the country under consideration before recommending it to your clients.
Fund manager risk
One major selling point for mutual funds is that they are professionally managed by expert fund managers. Before recommending a fund to clients, evaluate track record of the fund manager to mitigate risk.
However, fund manager risk does not end at this point. This risk also comes into play when an investor invests after evaluating a fund manager and the fund manager quits the AMC. Advisors need to help clients evaluate the new fund manager before taking a call on investments.
Another key risk is risk associated with NAV. To elaborate, mutual funds price their investments daily for NAV computation. Moreover, there is a continuous inflow and outflow of investor money. Let us assume that the fund faces a big redemption causing it to do distress sale to meet the liquidity. This will erode the funds’ corpus temporarily. In fact investors who stay invested may see lower NAV for a short period.
Investing in funds with large AUM can help mitigate this risk as they tend to have sufficient cash investments to meet the immediate liquidity requirement.
We all agree about the need for diversification. To achieve that you may invest your client’s money in multiple categories of schemes. However, a closer inspection of fund portfolios reveals that there is a significant overlap in top investments of many mutual fund schemes. Moreover, sometimes clients hold multiple schemes from the same category in their portfolio. This too leads to concentration.
You need to be cognizant of this risk and recommend truly diversified investment options to your clients.
Are there any other risks that you would like us to discuss? Share in the comment section below.