Risk and Return in Mutual Fund Investments

Published On: 07-Aug-2020

One must have heard the standard mutual fund disclaimer, "mutual fund investments are subject to market risks." As mutual funds generate returns through the underlying securities in the portfolio, several investment risks come along with mutual fund investments. Such mutual fund investment risks may vary from volatility risk, liquidity risk, interest rate risk, credit risk, etc. 

 

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All such risks primarily refer to the risk of the investors not being able to realize the actual potential of their investments. Similarly, the changes in the macroeconomic condition, like market interest rates, etc. may also cause changes in the valuation of the underlying investment portfolio.  

Such risks are indeed inherent to mutual fund investments. As such, the investors must take steps to align these risks to their respective risk profiles, instead of avoiding such risks and investing in traditional investment products. Different asset classes and their respective sub-categories of mutual fund schemes may carry different risk-reward trade-off. 

Since returns are seen as a reward for the risk being undertaken, return expectations must commensurate with such uncertainty. At the same time, the investors need to know that high return expectations may entail higher risk. However, higher risk assumed does not guarantee higher returns automatically. As such, the investors must balance the investment portfolio's risk profile by designing a suitable investment portfolio, albeit with appropriate moderation in the mutual fund scheme return expectations. 

The broad spectrum of mutual fund schemes available may broadly be classified into two categories – debt funds and equity funds. While debt funds invest predominantly in the debt securities, equity funds create an investment portfolio primarily consisting of equity shares. As such, such funds broadly carry a similar risk profile as that of the underlying asset class. 

Debt funds intent to provide returns, while equities equip the investors with the long-term potential for wealth creation. At the same time, equity markets also tend to be volatile over the short term and thus, not suitable for short term financial goals. 

However, investors may further finetune the risk profile by choosing between different mutual fund schemes. For example, within debt funds, investors may choose to invest in money market funds, duration funds, gilt funds, credit opportunities funds, etc. While gilt funds may carry insignificant credit risk with the portfolio comprising the sovereign securities, the typically high duration for such funds may expose the investors to the interest rate risk. 

Such risk is directly proportional to the Macaulay duration of such funds. In contrast to gilt funds, Credit Opportunities funds aim to capitalize on the prevailing higher credit spreads and thus, generating higher returns for the investors. However, the underlying investment portfolio also tends to expose the investors to credit risk depending upon the credit quality of the underlying investment portfolio. As such, the investors may choose the suitable debt fund to balance their risk-reward trade-offs. 

Similarly, within the overall basket of equity funds, one may invest in funds based on market capitalization, investing strategy, Equity Linked Savings Scheme (ELSS), etc. While an aggressive investor may be comfortable investing in small-cap funds, a conservative investor may be more comfortable investing in large-cap funds, dividend yield funds, etc. Investors may also consider investing in hybrid funds to balance equity and debt with a single investment product. 

While the investors may also manage the asset allocation within the investment portfolio by themselves, they may also automate the process by investing in dynamic asset allocation funds. Such funds adjust the equity and debt levels based on their relative valuations. As such, when the equity valuations are inexpensive, the equity exposure is increased. On the other hand, when the valuations are trading higher in equity markets, the equity exposure is reduced by booking profits at higher levels. This allows the downside protection to the investment portfolio during subsequent market corrections. 

As such, the investors may balance their risk-reward trade-off in their investment journey with optimal asset allocation strategies, whether by investors themselves or through dynamic asset allocation funds