Mutual Funds & Market Risks


By

Davinder Kaur
Lecturer (Finance)
MBA Dept.
Ludhiana College of Engineering & Technology
Ludhiana
 


THE INDIAN WAY

The Mutual Funds originated in UK and thereafter they crossed the border to reach other destinations. The concept of MF was Indianized only in the later part of the twentieth century in the year 1964 with its roots embedded into Unit Trust of India (UTI). Now after 50 years, booming stock markets & innovative marketing strategies of mutual fund companies in India are influencing the retail investors to invest their surplus funds with different schemes of mutual fund companies with or without complete understanding of Mutual Funds (MF).

It's a hard fact that investments in mutual fund is always risky. Investors should always be conscious of the fact that Mutual Funds invest their funds in capital market instruments such as shares, debentures, bonds etc and that all the capital market instruments have risk. Risks can be Investor Psychology Risks, Prediction Risks, Choice Risks, and Cost Risks etc.

Even there is no one mutual fund that will be suitable to all kinds of investors. Hence, mutual fund investors need to identify a suitable fund for them. It will be the first step towards making successful investments in mutual funds to make Mutual Funds their
"CUP OF TEA".

Identifying a suitable fund can be done in a two-step manner as follows:

* Selecting a fund with investment objectives and preferences, return objectives, time horizon and risk tolerances that meet the requirements of the investor.

* Selecting a fund that has a detailed asset allocation strategy by fund type category to reflect the investment objectives of the fund.

Mutual funds can be win-win option available to the investors who are not willing to take any exposure directly to the security markets as well as it helps the investors to build their wealth over a period of time. But the thing which must be remembered by the investors is "INVESTMENT IN MUTUAL FUND IS SUBJECT TO MARKET RISK".
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The Indian Equity Market has grown significantly during the last one year; Mutual Funds are not left far behind. Both the avenues have created wealth for the investors. But for the creation of wealth through this avenue a proper understanding of the Mutual Funds is must.

Understanding Mutual Funds

A Mutual Fund is a trust that pools the savings of a number of investors who share a common financial goal. The money thus collected is then invested in capital market instruments such as shares, debentures and other securities. The income earned through these investments and capital appreciation realized is shared by its unit holders in proportion to the number of units owned by them.


Thus a Mutual Fund is the most suitable investment for the common man as it offers an opportunity to invest in a diversified, professionally managed basket of securities at a relatively low cost.

When we talk about all these, one hard fact is about risks that are faced by the Mutual Fund investors. Whenever we see any Mutual Fund offer, there are few statements inevitably found along with that, which is commonly known as "Disclaimer Clause of the Mutual Fund".

Disclaimer of the Mutual Fund

"Mutual fund investments are subject to market risks. Please read the offer document carefully before investing. There is no assurance or guarantee that all the objectives of the fund will be achieved. Past performance of the Sponsors/ Mutual fund/ Schemes/ Asset Management Company is not necessarily indicative of future results. The name of the fund/ scheme does not, in any manner, indicate either the quality of the fund, its future prospects or returns".

It may be interpreted that under there is greater amount of risk involved in the subject matter; even if the disclaimer statement(s) are not too lengthier. In fact, these disclaimers, directly or indirectly, give a clear message that investors should be informed, take adequate care and beware of the inherent risks before investing in the mutual fund. Now the issue is what those Risks are?

1. Investor Psychology Risk:

The investor psychology is such that most of the investors, be it Mutual Fund Investors or Direct Capital Market Investors, behave like reactionaries. E.g. they enter the market when the share prices starts rising and they get panicky & exit as soon as share prices starts falling. Therefore, whether it is shares of company or mutual fund unit investors, investors resort to selling their investments when market starts looking down. Because of this, there will be more than normal demand on Mutual Fund manager to redeem the units. To honor the redemption demands of the exiting unit holders during the worst market times, Mutual Funds are forced to sell more stocks at the prevailing low prices. As a result of this, along with the redeeming unit holders, all the other unit holders who have invested in the fund suffer. This means, irrespective of one being a long-term buy and hold investor or not, he suffers because of investing in Mutual Fund.

2. Choice Risks:

All the experts recommend different schemes/ funds. Naturally, all of them cannot be and will not be right. Investors are also advised to stay invested for long-term to reap good returns. These experts also suggest different funds at different times. Of course, to be in the well-being fund, one needs to move from fund to fund intermittently. In an tempt to stay invested for a long-term and to be in the well-doing fund, the investor, whether educated and informed, will have to be satisfied with disappointment.

3. Cost Risks:

Mutual Funds charge huge fees that they can get away with and that too in the most confusing manner possible. The fund managers never intend to make their costs clear to their clients. It would not be painful for the investors to pay for the expenses and costs of the funds when they derive satisfactory returns. But, the irony is that investors have to pay for the sales charges, annual fees and many other expenses irrespective of how the fund has performed.

4. Prediction Risks:

Nobody can predict the capital market perfectly and can always find good investments. Similarly, the fund manager's predictions of future actions and outcomes are, of necessity, subject to error.

5. Jargon Risks:

The newsletters and other documents that are distributed to the investors do report so much and that too in such a language filled with technical jargons that it will not be very easy for an investor to understand and follow the report.

6. Competition Risks:

Return is ultimate measure of job performance for any investment, be it in a mutual fund or otherwise. Performance is the matter of comparison and the evaluation is intended to measure how the fund has performed vis--vis its past performance, peers and market. At present, Mutual Funds are required to report their performance including returns on a quarterly basis. Therefore, to prove that the fund is performing well, managers focus on quarterly returns. Buying & Selling of stocks at the end of quarter will be done to report better quarterly returns and to make funds holdings look better based on recent market action. In this process, where the competition is not really productive, fund managers incur expenses & losses that are naturally passed on to the unit holders.

7. Risk of Redemption Restrictions:

Whether informed in writing or not, normally the liquidity of schemes investments may be restricted by the trading volumes settlement period and transfer procedures.

8. Management Change Risks:

It is not uncommon for a Mutual Fund to have changes in its management. The change in the funds management may effect the achievement of the objectives of the fund. The fund company may, for various reasons, replace a fund manager or may be the fund manager himself may resign from his job for any reason. This change will be significant since the fund manager controls the fund investments.

9. Judgement Risks:

Investors may not know more than the fund manager about the investment strategy and whatever judgement the investor makes will not be fool proof.

10. Forward Pricing Risks:

The prices of a Mutual Fund do not change during the day. Order placed up to a cut off time of 3:00 p.m. get that day's Net Asset Value (NAV) and orders placed after 3:00 p.m. receive the next day's NAV. This is called the rule of forward pricing. This system assures a level playing field for investors. No investor is supposed to have the benefit of post 3:00 p.m. information prior to making an investment decision.

11. Breakpoint Risks:

Mutual Fund charge loads such as front end & back end. Few Mutual Fund charge front end sales load will charge lower sales loads for larger investments. The investment level required to obtain a reduced sales load are known as breakpoints. These breakpoints lure investors to invest huge funds to avail the discounts on volumes and end up losing focus on his planned diversification for his Mutual Fund investments.

12. Risks of Blind Diversification:

It may happen that a fund is heavily committed to a particular area of the economy at any given time. This is called blind diversification risk and any investor would like to invest in Mutual Fund that concentrate in asset classes that he himself has not invested at his own.

13. Risks of changes in the Regulatory Norms:

Mutual Funds are constantly regulated by SEBI and investors are subject to risk of the changes in the norms for the Mutual Funds.

Besides the above risks, Mutual Funds will also have the common risks that any investment has. In fact, risk is present in every decision made with regard to the investments in capital markets. Following is the list of some common risks involved while investing in the capital markets and particularly in the mutual funds:

* Country Risk : This risk arises from the possibility that political events such as war, national elections etc. and financial problems such as rising inflation or natural disasters such as an earthquake, a poor harvest etc. will weaken a country's economy and cause investments in that country to decline.

* Credit Risk: This is a risk that arises from the possibility that a bond issuer will fail to repay interest and principal in a timely manner. This risk is also called as default risk.

* Currency Risk: This risk arises from the possibility that returns could be reduced for Indians investing in foreign securities because of a rise in the value of the Indian rupee against dollar, euro or yen etc. This is also known as Exchange Rate Risk.

* Industry Risk : This risk arises from the possibility that a group of stocks in a single industry will decline in price due to developments in that industry.

* Manager Risk : This risk arises from the possibility that an actively managed mutual fund's investment adviser will fail to execute the fund's investment strategy effectively, resulting in the failure of the sated objectives.

* Market Risk: This risk arises from the possibility that stock fund or bond fund prices overall will decline over short or even extended periods.

* Principal Risk : This risk arises from the possibility that an investment will go down in value, or lose money from the original or invested amount.

Investors' Responsibility in Investing

* Read the Mutual Fund Prospectus completely.
* Investors must be particular about the objectives.
* How much they should rely upon the name of the scheme or objectives.
* What initiate the investors to purchase the mutual fund units?
* Understanding the investment strategy of the fund investments.
* Whether the investment strategy will lead to the achievement of the objectives of the scheme.
* Whether old investors receive any investment advice from the mutual funds besides the newsletter.
* Whether investors manage their mutual fund investments or do they just invest and stay passive.
* Whether investors compare the performance the performance of the scheme with other schemes or other funds.
* Whether investors face any problem with regard to the NAV pricing.
* Whether breakpoints lure investors.
* Whether investors realize any blind diversification.
* What do investors expect from Sebi as a regulator?

The Way Forward for the Mutual Fund Investors

There is no one mutual fund that will be suitable to all kinds of investors. Hence, mutual fund investors need to identify a suitable fund for them. This would be the first step towards making successful investments in mutual funds. Identifying a suitable fund can be done in a two-step manner as follow:

a. Selecting a fund with investment objectives and preferences, return objectives, time horizon and risk tolerances that meet the requirements of the investor.

b. Selecting a fund that has a detailed asset allocation strategy by fund type category to reflect the investment objectives of the fund.

To select a suitable fund, investors should read the fund's prospectus completely before making investment. By reading investment objectives, the fund's financial goals and the type of securities chosen can be known. An investor can make out whether or not a fund is advisable for him by determining if the goals are congruent with his own investment goals. Investor should also ensure that the fund is comparing itself with an appropriate benchmark. Another important aspect investors have to carefully examine is the fees and expenses charged by the fund.

Finally, investors should always be conscious of the fact that mutual funds invest their funds in capital market instruments such as shares, debentures, bonds and money market instruments, and that all the capital market instruments have risk. Therefore an investor is supposed to have full knowledge and understanding that mutual fund investments are subject to market risk and should manage the risks carefully for a safe and happy investment.
 


Davinder Kaur
Lecturer (Finance)
MBA Dept.
Ludhiana College of Engineering & Technology
Ludhiana
 

Source: E-mail October 10, 2007

          

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