General and Specific Risk Factors :
- This chapter focuses on understanding risks involved in mutual fund investments.
- Risks are classified as standard/general and asset-specific.
- Investors must know which risks they are exposed to and how to manage them.
- Mutual fund structures and fund managers mitigate some risks, while others remain with the investor.
- The Scheme Information Document (SID) outlines:
- Standard risk factors (common to all mutual funds)
- Specific risk factors (e.g., credit risk for debt, currency risk for foreign assets)
- SID also includes risk mitigation strategies.
General Risk Factors in Mutual Fund Investments :
- Investment Risk: Mutual fund investments carry risks like market volatility, settlement delays, liquidity issues, default risk, and potential loss of principal.
- Market Impact: The Net Asset Value (NAV) of schemes may fluctuate due to macroeconomic factors like interest rates, currency changes, government policy, taxation, and market volatility.
- Performance Disclaimer: Past performance and scheme names are not indicative of future returns or scheme quality.
- Sponsor Liability: Sponsors are only liable up to their initial contribution and not for any subsequent losses.
- Liquidity Risk: Limited market depth, trading volumes, and secondary market inefficiencies may hinder buying/selling securities, causing losses.
- Interest Rate Risk: Fixed-income security prices inversely relate to interest rate changes; longer maturity increases sensitivity.
- Reinvestment Risk: Cash flows from investments may be reinvested at lower interest rates, reducing total returns.
- Political Risk: Political instability or unfavorable government policies may negatively impact markets and mutual fund performance.
- Economic Risk: Economic slowdown or fiscal imbalance may reduce investment opportunities and returns.
- Foreign Currency Risk: Foreign investors face exchange rate fluctuations, and currency risk is not managed by the AMC.
- Settlement (Counterparty) Risk: Derivative transactions and floating rate swaps carry the risk of default by counterparties.
- Exchange Transaction Risk: Unit transactions on stock exchanges depend on the efficiency of the exchange systems and are outside the Fund’s control.
Specific Risk Factors :
- Equity Market Risk: Equity investments are highly volatile and sensitive to market conditions, liquidity constraints, and external factors like interest rates, government policies, and global events.
- Short Selling & Securities Lending Risk: Involves counterparty risk and potential loss from illiquidity or default, which can lead to significant financial impact.
- Mid- & Small-Cap Risk: These stocks carry higher volatility and liquidity risk, despite their growth potential, making investments in them inherently riskier.
- Dividend Risk: Dividends are not guaranteed; companies may reduce or stop dividend payments, impacting returns.
- Derivatives Risk: Derivatives are complex, leveraged instruments subject to risks like counterparty default, liquidity issues, mispricing (model risk), and execution challenges.
- Debt Fund Risk: Includes reinvestment risk, rating migration risk, interest rate sensitivity, and credit risk based on issuer reliability and security type.
- Floating Rate Security Risk: Exposed to spread risk and basis risk if benchmark rates change unpredictably or become inactive.
- Corporate Bond Repo Risk: Counterparty failure can lead to losses, though mitigated by over-collateralization.
- Segregated Portfolio Risk: Illiquidity and valuation uncertainty affect unit holders, especially if the recovery from the issuer is delayed or fails.
- Securitized Asset Risk: Includes asset class-related risks, pool characteristics like loan size, LTV ratio, maturity, seasoning, and default rate distribution, all influencing repayment reliability.
- Credit Enhancement in Securitisation: Enables achieving higher credit ratings than the originator by filtering asset classes and ensuring timely payments through enhancements if receivables fall short.
- High-Rated Investments: Schemes primarily invest in AA-rated or above securitised instruments, though ratings may change or be withdrawn.
- Liquidity & Price Risk: Limited secondary market for securitised papers can affect resale value.
- Limited Recourse & Delinquency: Investors have no recourse to issuers/originators; defaults may erode credit enhancements.
- Prepayment Risk: Prepayments can alter yield/tenor expectations.
- Bankruptcy Risks: Legal structuring aims to mitigate originator or agent bankruptcy risks.
- Co-mingling Risk: Potential loss if servicers delay fund remittance.
- REITs/InvITs Risks: Include interest rate, credit, and distribution risks.
- Risk Management Strategies: Liquidity, credit, interest rate, rating migration, reinvestment, and equity risks are actively managed.
- Limited Floating Rate Exposure: Due to low liquidity and price discovery issues.
Factors that affect mutual fund performance :
- Mutual fund performance is influenced by both the asset class characteristics and the strategies adopted by fund managers.
- Systematic (market) risk affects the entire economy and cannot be diversified away, while unsystematic (company-specific) risk can be reduced through diversification.
- Fund managers may tactically move between cash and equity to manage systematic risk, but SEBI regulations limit cash allocation in certain schemes.
- Some fund managers stay fully invested, believing investors accept the inherent risks of the scheme.
- Only non-diversifiable risks (systematic) are rewarded, as per finance theory; active managers must take some unsystematic risks to beat the benchmark.
- Mutual funds are pass-through vehicles, meaning investment risks are borne by the investors, unlike fixed deposits where returns are guaranteed.
- Diversification helps manage credit and unsystematic risks but cannot protect against market-wide fluctuations.
- The Net Asset Value (NAV) of equity-based funds fluctuates with market conditions, whereas low-volatility funds like overnight funds remain stable.
- Risk in mutual funds arises from the underlying investments, not the fund structure itself.
- Market-wide price movements impact all securities and cannot be mitigated through diversification.
Drivers of Returns and Risk in a Scheme :
- Portfolio Composition: Returns and risks in mutual funds depend on the asset class, sector focus, security selection, and portfolio strategies.
- Factors Affecting Performance of Equity Funds
- Equity returns arise from price appreciation, while risks stem from earnings volatility. Success depends on thorough analysis and portfolio deviation from the benchmark.
- Investment Strategies:
- Security Selection: Choosing fundamentally strong stocks.
- Market Timing: Buying/selling at optimal times.
- Analysis Methods:
- Fundamental Analysis: Evaluates business fundamentals using metrics like EPS, P/E, PEG, Book Value, and Dividend Yield.
- Technical Analysis: Studies price-volume trends to guide short-term trades.
- Investment Styles:
- Growth Investing: Focuses on high-growth stocks, often expensive and volatile.
- Value Investing: Targets undervalued stocks with long-term potential.
- Portfolio Approaches:
- Top-Down: Starts with macroeconomic trends, then industry and company.
- Bottom-Up: Begins with individual company analysis.
Factors Affecting Performance of Debt Funds
- Driven by interest rate risk and credit risk.
- Return comprises interest income and capital gains/losses from price movements.
- Types of Debt Instruments: Includes G-Secs, T-Bills, CDs, CPs, Bonds, and Debentures with varying tenors and risks.
- Interest Rate Impact: Inverse relationship between market rates and bond values; managed via modified duration and instrument choice (fixed vs. floating).
- Credit Risk and Spread: Ratings affect yields; rising creditworthiness boosts security value. Managers may strategize based on rating changes.
- Fund Objectives and Strategies:
- Some funds focus on stable accrual (e.g., liquid funds).
- Others aim for capital gains via interest rate or credit spread movements (e.g., dynamic bond funds).
Factors Affecting Performance of Gold Funds
- No Current Income: Gold does not generate regular income; returns depend solely on selling price exceeding purchase price.
- Global Price Impact: Prices fluctuate due to global demand-supply, geopolitical events, and actions by institutions like central banks and the IMF.
- Rupee Strength: A stronger rupee lowers gold returns in INR; a weaker rupee boosts them.
- Passive Fund Management: Gold funds are passive; fund managers do not take active price calls.
Factors Affecting Performance of Real Estate Funds
- Local Asset: Real estate is location-dependent and affected by local economic conditions.
- Economic Conditions: Prices decline in downturns and rise with economic improvement.
- Infrastructure: Better infrastructure raises property values.
- Interest Rates: Low interest rates stimulate demand; high rates suppress it.
- Asset Type & Innovation: Returns vary by type (residential, commercial, etc.) and investment structure.
- Income Sources: Returns come from rental income and capital gains, with the latter being unpredictable.
- Valuation Rules: SEBI mandates neutral agencies for valuation; currently, no mutual fund schemes invest in real estate.
Measures of Returns :
- Return Calculation: Returns are computed by comparing investment inflows (income, capital gains) against outflows (initial cost), including unrealized gains/losses.
- Simple Return: Measures the percentage change in investment value over a period using the formula:
(LaterValue−InitialValue)/InitialValue(Later Value – Initial Value)/Initial Value(LaterValue−InitialValue)/InitialValue. - Annualized Return: Allows comparison across timeframes by converting returns to an annual basis.
- Compounded Return: Accounts for reinvestment of earnings; calculated using
(LaterValue/InitialValue)(1/n)−1(Later Value / Initial Value) ^ (1/n) – 1(LaterValue/InitialValue)(1/n)−1. - CAGR: Captures the effect of both compounding and dividend reinvestment using SEBI-prescribed methods.
- Investor vs. Scheme Returns: Investor returns may differ due to loads (entry/exit) and tax implications; use actual paid/received amounts for accurate figures.
- Holding Period & Rolling Returns: Holding period returns are based on fixed durations, while rolling returns average multiple overlapping periods to smooth anomalies.
- Return Evaluation Limits: Returns alone are not enough; consistency, benchmark comparison, and risk (like return volatility) are also crucial for investment decisions.
SEBI Norms regarding Representation of Returns by Mutual Funds in India :
- Mutual funds in India cannot promise returns unless under an assured returns scheme.
- Assured returns schemes must name a guarantor in the Scheme Information Document (SID), who is liable to cover shortfalls.
- SEBI prescribes an Advertisement Code and guidelines for performance disclosures by mutual funds.
Risks in fund investing with a focus on investors :
- Investor Perspective on Risk: Fund risks must be understood in context of investors’ financial goals; distributors must match scheme risks with investor profiles.
- Equity Fund Risks: Include market volatility, business risk (higher in small-caps), and liquidity risk. Focused funds amplify these due to concentrated portfolios.
- Debt Fund Risks: NAV fluctuations arise from interest rate changes and credit risk. Many investors are unfamiliar with such volatility due to preference for fixed-return instruments.
- Liquidity and Segregated Portfolio Risk: In credit events, absence of a segregated portfolio can increase exposure for remaining investors.
- Low-Risk ≠ No-Risk: Even short-duration debt funds can be affected by credit defaults, disproving the assumption of absolute safety.
- Regulatory Measures: SEBI mandates listing of units in winding-up schemes on stock exchanges to offer investor exits.
- Hybrid Fund Risks: Though considered balanced, some hybrid strategies (e.g., merger arbitrage) involve directional market bets, carrying risks.
- Gold Fund Risks: Gold offers crisis-time value and pricing transparency, but is still subject to price declines, risking investor losses.
- Real Estate Fund Risks: Include illiquidity, valuation subjectivity, regulatory and governance issues, making them riskier than most funds but safer than direct real estate investment.
Measures of Risk :
- Risk is measured through return fluctuations, assessed over different time periods and compared to average returns.
- Variance quantifies how much returns deviate from the average; higher variance indicates more fluctuation and risk.
- Standard Deviation is the square root of variance, representing total risk; it’s commonly annualized using square root of the number of periods.
- Beta measures a scheme’s volatility relative to the market; beta >1 implies higher risk than the market, and <1 implies lower risk.
- Modified Duration reflects a debt instrument’s sensitivity to interest rate changes; higher values indicate greater sensitivity.
- Weighted Average Maturity estimates interest rate sensitivity based on time to maturity; longer maturities imply higher risk.
- Credit Rating assesses default risk in debt securities; higher ratings mean lower risk and lower yields, while downgrades lead to value decline.
Certain Provisions with respect to Credit risk :
- Credit Risk in Debt Markets: Arises from defaults, delays, or rating downgrades—collectively termed as credit events—leading to price drops and reduced liquidity in affected securities.
- Redemption Impact Example: If a mutual fund heavily exposed to a downgraded security faces large redemptions, its proportional exposure to the affected security increases, heightening risk for remaining investors.
- Liquidity Crisis & Redemption Restrictions: SEBI allows mutual funds to restrict redemptions only during market-wide liquidity crises, not for issuer-specific issues; restrictions require trustee and AMC board approval and are capped at 10 working days in 90 days.
- Redemption Restriction Rules: First ₹2 lakhs of redemption per investor is exempt; amounts beyond this can be restricted; such provisions must be clearly disclosed in fund documents.
- Segregated Portfolio (Side-Pocketing): Allows AMCs to isolate downgraded or defaulted securities from the main portfolio, protecting unaffected assets and investors from contagion risk.
- Conditions for Segregation: Applicable on credit rating downgrade or actual default (for unrated instruments); trustees must approve; NAVs of both portfolios are disclosed separately.
- Investor Treatment: Investors receive equivalent units in the segregated portfolio but cannot redeem or subscribe further in it; however, AMCs must list units for trade within 10 working days.
- Expense Management: No advisory fees on segregated portfolios; TER (excluding advisory fees) can be charged post-recovery; legal costs can be charged within TER limits.
- Risks of Segregated Portfolios: Include illiquidity, potential full loss of value, and disparity between trading price and NAV on exchanges.
- Risk Mitigation Strategies:
- Equity Funds: Longer holding periods reduce return volatility.
- Debt Funds: Use of high-rated securities and matching holding periods with fund maturity can reduce interest rate and credit risk.