Mutual Fund Risks and Assessing it with a Mutual Fund Riskometer: Indus NZ
Introduction
Well, Indian mutual funds seem to be a big draw. Apparently, quite a bit of money has flowed in. There are definitely mutual fund risks involved with different kinds of investments, of which you should definitely be aware of.
Jumping into investments without assessing these risks can lead to outcomes that don't align with your financial goals.
This blog will help you break down those mutual fund risks you keep hearing about and, importantly, show you how they connect to what you're trying to achieve financially.
Plus, we'll decode the Securities and Exchange Board of India (SEBI)-mandated Mutual Fund Riskometer. This cool tool can be a real game-changer, helping you pick funds that aren't just chasing returns, but actually match how much risk you're comfortable taking.
Explore how Indus works and how we can assist you in your investment journey.
What Are Mutual Fund Risks
In simple terms, mutual fund risks refer to the possibility of losing the money you've invested in a mutual fund scheme.
Unlike guaranteed return schemes, the Net Asset Value (NAV) of a mutual fund fluctuates based on the underlying investments. Several factors contribute to these fluctuations, and understanding them is crucial for making informed decisions.
Here’s a breakdown of the six core threats to your NAV:
1. Market Risk:
This is the one of the most pervasive mutual fund risks, stemming from the overall performance of the financial markets.
Economic downturns, political instability, or even changes in investor sentiment can cause the value of stocks and bonds held by the fund to decline, consequently impacting the NAV.
2. Credit Risk:
This risk, compared to other mutual fund risks, is primarily associated with debt funds. It refers to the possibility that the issuers of the debt securities (like companies or governments) held by the fund may default on their interest payments or principal amount.
Higher credit risk generally translates to potentially higher returns, but also a greater chance of loss.
3. Interest-Rate Risk:
Again of all mutual fund risks, this mainly affecting debt funds, this risk arises from fluctuations in prevailing interest rates. When interest rates rise, the value of existing fixed-income securities typically falls, and vice versa.
Funds holding long-term debt are generally more sensitive to interest rate changes.
4. Liquidity Risk:
This refers to the ease with which the fund can sell its underlying investments without significantly impacting their market price. For most well-established mutual funds, this isn't a major concern among other mutual fund risks.
However, funds investing in less liquid assets, such as certain types of real estate or unlisted securities, might face challenges when they need to sell quickly to meet redemptions.
5. Concentration Risk:
Some mutual funds focus their investments in a specific sector, theme, or a limited number of holdings. If that particular area underperforms, the fund's NAV can be significantly impacted.
Diversification across different sectors and asset classes helps mitigate this risk among other mutual fund risks.
6. Currency Risk:
This is particularly relevant for NZ-based NRIs investing in Indian mutual funds. The value of the Indian Rupee (INR) relative to the New Zealand Dollar (NZD) can fluctuate.
If the INR depreciates against the NZD, the returns you receive in INR might translate to lower returns when converted back to NZD, and vice versa.
Ultimately, the various mutual fund risks highlight the importance of thorough research and due diligence.
A clear understanding of what could go wrong empowers investors to make educated choices that are in line with their financial objectives and risk appetite.
SEBI’s Mutual Fund Riskometer
To help investors better understand and assess mutual fund risks, SEBI has mandated the use of a Mutual Fund Riskometer.
This is a colour-coded dial that appears prominently on the Scheme Information Document (SID) and Key Information Memorandum (KIM) of every mutual fund scheme. Think of it as a quick visual guide to the level of risk associated with a particular fund.
The Mutual Fund Riskometer features six distinct risk bands:
Low (Blue): Indicates schemes with the lowest level of risk among mutual fund risks.
Low-to-Moderate (Light Blue): Suggests a slightly higher level of risk compared to the "Low" category.
Moderate (Green): Represents a balanced level of mutual fund risks.
Moderately High (Yellow): Signals a considerable level of risk.
High (Orange): Denotes schemes with a significant degree of risk.
Very High (Red): Indicates schemes with the highest potential for volatility and losses.
SEBI, through its circular dated 2023/150, also mandates that Asset Management Companies must review and update the mutual fund risks labels of their schemes at least once a year.
This ensures that the Mutual Fund Riskometer accurately reflects the current risk profile of the fund based on its underlying investments and market conditions.
The beauty of the Mutual Fund Riskometer lies in its simplicity. At a glance, you can instantly gauge whether a fund's inherent mutual fund risks align with your personal risk tolerance.
Conservative investors usually gravitate towards funds in the "Low" or "Low-to-Moderate" categories.
Conversely, investors with a higher risk appetite and a longer investment horizon, consider funds in the "High" or "Very High" categories.
Matching Riskometer Bands with Common Fund Categories
Understanding which types of mutual funds typically fall into each Mutual Fund Riskometer band can further streamline the fund selection process.
According to Telegraph India, SEBI wants additional investor disclosure from mutual funds in form of more granular ‘riskometer’.
It gives you a quick snapshot of the inherent mutual fund risks level associated with different investment categories.
Low:
Generally, Liquid funds and Overnight funds fall into this category. These funds invest in very short-term debt instruments, making them relatively stable and less sensitive to market fluctuations.
Low-to-Moderate:
Short-Duration Debt funds typically reside in this band of mutual fund risks. They invest in debt securities with a slightly longer maturity than liquid funds, thus carrying a bit more interest rate and credit risk.
Moderate:
Balanced Advantage funds (also known as Dynamic Asset Allocation funds) often fall into the "Moderate" risk category.
These funds dynamically adjust their allocation between equity and debt based on market conditions, aiming to provide a balance between growth and stability.
Moderately High:
Large-Cap Equity funds, which primarily invest in the stocks of the largest companies, are usually classified as "Moderately High" risk.
While large-cap stocks tend to be more stable than smaller companies, they are still subject to market volatility, when compared to mutual funds vs stocks.
High:
Mid-Cap funds and Small-Cap funds, investing in companies with medium and small market capitalization respectively, typically fall into the "High" risk category among mutual fund risks.
These stocks have the potential for higher growth but also carry greater volatility.
Very High:
Sectoral or Thematic funds, which concentrate their investments in specific industries or themes, and crypto-linked Funds of Funds (FoFs) generally fall under the "Very High" risk label.
This is primarily due to their concentrated nature and the inherent volatility of the underlying assets.
While the typical alignment of fund categories with Riskometer bands provides a helpful starting point, it's vital to treat each mutual fund as a unique entity.
Investors scrutinize the individual fund's Riskometer and other relevant documents to ensure it truly matches their tolerance to mutual fund risks and investment objectives.
Why Mutual Fund Risks Feel Different for NZ-Based NRIs
Investing in Indian mutual funds from New Zealand? While the core risks are the same, there's a unique twist for you.
You're not just dealing with market ups and downs in India, but also the rules for sending money across countries. Moreover, how you get taxed can add a whole other layer to the risk picture.
And if you’re an HNW NRI, you should also know about Alternative investment funds.
Being on the other side of the world also means keeping up with news and reacting to changes might feel a bit different.
So, while everyone faces the mutual fund risks, as an NRI in New Zealand, you've got a few extra things to keep in mind.
1. INR ↔ NZD Volatility:
The exchange rate between the Indian Rupee and the New Zealand Dollar is subject to fluctuations.
Historically, the rupee has depreciated against the Kiwi dollar. Which means that INR has become more volatile and less valuable compared to the New Zealand Dollar.
Consequently, you now need more rupees to purchase the same amount of Kiwi dollars. According to Moneycontrol, RBI intervention in forex rises as Indian Rupee turns volatile.
This currency risk, among mutual fund risks, can significantly impact your overall returns. When you convert your INR-denominated mutual fund investments back to NZD, you might lose out on maximizing your returns.
2. Time-Zone Information Lag and Headline Swings Overnight:
The time difference between New Zealand and India means that you might receive market-moving news overnight. This information lag can make it challenging to react quickly to market events affecting your Indian mutual fund investments.
3. Tax Quirks:
Understanding the tax implications in both India (Short-Term Capital Gains - STCG, and Long-Term Capital Gains - LTCG) and New Zealand (Foreign Investment Fund - FIF regime) is crucial.
Without proper planning, these tax rules can erode your investment returns. You should also be aware of the DTAA between India and New Zealand to effectively manage your taxes.
Step-by-Step: Using the Mutual Fund Riskometer to Build Your Portfolio
Leveraging the Mutual Fund Riskometer effectively can help you construct a portfolio that aligns with your financial goals and tolerance to mutual fund risks, especially crucial for NRIs in New Zealand navigating the Indian market.
Here's a step-by-step approach:
1. Define Each Life Goal’s Horizon:
To avoid certain mutual fund risks, clearly define the time frame for each of your financial goals. Short-term goals typically have a horizon of less than 3 years, medium-term goals range from 3 to 7 years, and long-term goals extend beyond 7 years.
2. Take a Risk-Profiling Questionnaire:
Honestly assess your risk tolerance by answering a comprehensive risk-profiling questionnaire. This will help you understand your comfort level with potential investment losses.
3. Filter Schemes by Riskometer Band:
Based on your risk profile, filter mutual fund schemes by their Mutual Fund Riskometer band. For instance, if you have a moderate tolerance towards mutual fund risks, you might focus on funds labeled "Moderate."
4. Diversify Across Two or Three Adjacent Bands:
To potentially smoothen out volatility, consider diversifying your portfolio across two or three adjacent Mutual Fund Riskometer bands. For example, a moderately conservative investor might allocate across "Low-to-Moderate" and "Moderate" risk funds.
5. Review Twice a Year:
Regularly review your portfolio and the Mutual Fund Riskometer labels of your chosen schemes. AMCs can and do change these labels based on evolving market conditions and the fund's investment strategy.
Quantify Risk with Simple Ratios
While the Mutual Fund Riskometer provides a qualitative assessment of mutual fund risks, investors also use quantitative ratios to gain a deeper understanding.
These offer a more data-driven perspective, especially helpful for NRIs. Here are a few key ratios to consider:
1. Standard Deviation:
This measures the volatility of a fund's returns around its average return. A higher standard deviation indicates higher volatility.
2. Sharpe Ratio:
Think of the Sharpe Ratio as a way to see how much extra return you're getting from a mutual fund for every bit of risk you take. It's like asking, "Is this fund paying me enough to deal with the potential ups and downs (the mutual fund risks)?".
A higher number here is usually a good sign because it means the fund is delivering better returns without taking on too much extra risk. It helps you compare different funds and see which ones are giving you more bang for your risk buck.
3. Sortino Ratio:
Now, the Sortino Ratio is a bit like the Sharpe Ratio, but it's specifically for folks who really don't like losing money. Instead of looking at all the ups and downs (both good and bad), it only focuses on the bad ones – the times when the fund's value goes down.
So, it tells you how well a mutual fund performs while protecting you from those negative mutual fund risks. If you're someone who gets nervous when your investments drop, a higher Sortino Ratio might be something you look for.
4. Maximum Drawdown:
The Maximum Drawdown is like measuring the biggest drop from the highest point to the lowest point during a certain period. It gives you a clear picture of the worst-case scenario you could have experienced with that fund.
This is a really direct way to understand the potential downside of mutual fund risks. A smaller Maximum Drawdown might be more appealing if you want to avoid big drops in your investment value.
You can also use Nifty Alpha and Momentum Index funds to use as a benchmark for tracking the performance of your investments.
It helps you mentally prepare for the kind of dips a fund might take.
Common Myths about Mutual Fund Risks
Let's clear the air on some common misunderstandings about mutual fund risks. Getting the facts straight is especially important for NRIs in New Zealand who might be getting information from various sources.
Myth: “High Mutual Fund Riskometer means guaranteed high returns.”
Reality: A higher risk label indicates the potential for higher returns, but it also comes with a greater possibility of significant losses. Risk and return are correlated, but high mutual fund risks don't guarantee high rewards.
Myth: “Debt funds are risk-free.”
Reality: All mutual funds carry some level of risk. Debt funds are subject to credit risk and interest rate risk, as discussed earlier.
Myth: “Last year’s high returns will repeat.”
Reality: Past performance is not indicative of future results. Market conditions and mutual fund returns can change significantly over time.
Don't let common misunderstandings cloud your judgment when it comes to mutual fund risks. However, equity mutual funds could be best for long term growth.
Correspondingly, while investing in mutual funds, you should look out for the apparent mutual fund overlap. Read our insights to avoid some of the common mutual fund mistakes.
By understanding and rejecting these myths, you empower yourself to make informed decisions aligned with your financial goals and risk tolerance. Apart from these, have a clear understanding about expense ratios of mutual funds.
A clear perspective on the true nature of mutual fund risks is crucial for a successful investment journey.
Leverage Indus NZ to Track Risk and Invest Seamlessly
For NZ-based NRIs looking to invest in India, Indus NZ offers a convenient platform with tools to help you manage mutual fund risks effectively.
You can browse over 500 Indian mutual funds, searchable by their Mutual Fund Riskometer band, allowing you to easily identify schemes that align with your risk profile.
Furthermore, Indus NZ provides a market-leading 1% FX spread on NZD to INR conversions, potentially preserving more of your investment capital for compounding.
Our digital KYC approval process takes just three minutes, eliminating the hassle of traditional paperwork.
We offer easy tax compliance by navigating the DTAA for you. You don’t even need an NRE account. See how easy it becomes?
While Indus NZ currently focuses on mutual funds, we have plans to include direct investment opportunities and debt mutual funds in the future.
Risk-Reduction Checklist
We’re giving you a simple checklist, like a little cheat sheet. investors tend to keep an eye out for these things and to make their investment journey a bit smoother. To further mitigate mutual fund risks, investors will:
Verify the latest Scheme Information Document (SID) and Key Information Memorandum (KIM), paying close attention to the investment objective, asset allocation, and the exit load structure.
Compare a scheme’s standard deviation and other risk ratios with the average for its category to understand its relative volatility.
Maintain a rupee-denominated emergency fund to avoid being forced to redeem your mutual fund investments during market downturns.
Rebalance your portfolio annually or as needed to maintain your desired asset allocation and risk profile.
Just run through this checklist. It's like a little safety net, helping you make smarter choices and knowing you've taken steps to manage those mutual fund risks. Investing should be about reaching your goals, not unnecessary stress.
Conclusion
Understanding mutual fund risks is paramount for successful investing.
The SEBI Mutual Fund Riskometer serves as a valuable tool, simplifying the process of assessing these risks and aligning your investment choices with your individual comfort level.
For NZ-based NRIs investing in India, Indus NZ further streamline this process by providing easy access to a vast pool of funds and efficient investment solutions.
Basically, get to know that Riskometer and use these ideas to mitigate the common mutual fund risks, and you're in a better spot to make your Indian investments from New Zealand work for you.
If you're curious about how to get going, take a look at Indus NZ. We make investing in India - Simplified!
FAQs in Mutual Fund Risks
1. What are the risks of investing in mutual funds?
Mutual funds carry various risks, including market risk (overall market fluctuations), credit risk (issuer default in debt funds), interest rate risk (changes in interest rates affecting bond values), liquidity risk (difficulty in selling investments), concentration risk (over-exposure to a specific sector), and inflation risk (erosion of purchasing power).
2. How can I minimize the risks in mutual funds?
Diversifying your portfolio across different asset classes and sectors is a key strategy. Investing through SIPs (Systematic Investment Plans) can help average out market volatility. Understanding your tolerance to mutual fund risks and choosing funds accordingly, and consulting a financial advisor are also crucial steps.
3. What is a riskometer in a mutual fund?
A riskometer is a graphical tool mandated by SEBI that visually represents the level of risk associated with a mutual fund scheme. It typically uses a colour-coded meter with different risk levels to help investors understand the potential volatility and downside of a fund.
4. How does the riskometer work?
The riskometer assesses the risk level of a mutual fund based on the types of assets it invests in (e.g., equity, debt), their market capitalization, volatility, and liquidity. It assigns the fund to one of six risk categories: Low, Low-to-Moderate, Moderate, Moderately High, High, and Very High.
5. What is the biggest risk of investing in mutual funds?
The biggest mutual fund risks is generally considered to be market risk, as it can lead to a decline in the value of the fund's investments regardless of the fund manager's expertise. However, for specific types of funds, other risks like credit risk (for debt funds) or concentration risk (for thematic/sectoral funds) can also be significant.
6. How often is the riskometer updated?
SEBI mandates that Asset Management Companies (AMCs) review and update the riskometer of their schemes at least once a year. Additionally, if there are significant changes in the fund's portfolio or market conditions that could affect its risk profile, the riskometer may be updated more frequently.
Standard Disclaimer
Investing involves risk, and returns are not guaranteed. Please conduct your own research before making any investment decisions. This information is provided for general purposes only and does not constitute financial advice.
Indus does not provide investment, financial, legal, or tax advice. While we facilitate access to Indian mutual funds, any decision to invest is solely your responsibility. You should consult a qualified financial adviser or tax specialist before making any investment or tax-related decisions, especially if you are uncertain about how these investments apply.
