3 mutual fund risks and how to beat them

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All mutual funds come with varying degrees of risks, but that doesn’t mean you should not invest in them. The thumb rule of building wealth is: if you want returns, you have to take a bit of risk. The trick is to know the tricks to beat the risks.

Volatility

Equity mutual funds, or for that matter all equity investments, are prone to volatility. In 2016, the S&P BSE Sensex returned 1.95%. In 2017, it gave 28% returns. So far in 2018, Sensex is down 3%. Mid-cap and small-cap indices—and by extension, the funds that invest in such companies—swing more wildly.

How to beat it: Two steps; if investing in equities, then avoid investing for the short run. Invest for the long term. By extending your investment tenure, you can cut out the effects of short-term volatility, which is typically severe. Mint Money recommends a minimum tenure of 5 years. The second step is to invest through a systematic investment plan (SIP). In this method, you buy less units when markets go up, but more units automatically, when markets go down.

Credit risk 

When the underlying investments of debt funds fail to repay their interest and principal amounts—and worse, when their credit rating is downgraded—debt funds suffer. We have seen some such accidents in the past 3 years. The erstwhile JP Morgan Asset Management (India) Ltd suffered on account of its investments in Amtek Auto Ltd, and Taurus Asset Management Co. Ltd took a hit on some of its debt funds due to a credit ratings downgrade of one of its underlying investments.

The reality is that a credit rating downgrade (which leads to a fall in the net asset value of a mutual fund scheme) can happen swiftly, sometimes in a matter of months.

How to beat it: Earlier, it was tough for you to know which debt funds would take on credit risk, and which ones would avoid them. Now, the capital market regulator, Securities and Exchange Board of India (Sebi), has made it easier to identify such funds. Thanks to the ongoing scheme reclassification exercise that Sebi started in 2017, credit funds will now be called credit risk funds, and it has specified that such funds will invest at least 65% of their assets in securities rated AA and below. Corporate bond funds will no longer be allowed to take credit risks beyond a point; these shall invest at least 80% of assets in securities rated AA+ and above.

Uncertain Market

The future is uncertain, but we all have financial goals that must be met. What’s worse is to see our portfolio grow over time, but one big bout of volatility in the final year (or the year in which we plan to withdraw) erasing a lifetime’s worth of gains.

How to beat it: Practise asset allocation in the portfolio. Ascertain your risk profile; these days many financial advisers and distributors have sophisticated tools to capture this information. Based on your results, allocate your money in equity and debt instruments and then adhere to that allocation.

Review your risk profile and tolerance once in a year or two and keep tracking your asset allocation. That’s another way to beat volatility.

[“Source-livemint”]