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Wednesday, 23 November 2016

Are mutual fund investments only subject to market risks?

'Mutual Fund investments are subject to market risk. Please read the offer document carefully before investing' says the disclaimer in the every advertisement of the mutual fund. Are mutual fund investments subject to market risks alone? Read this space to know what are the risks mutual funds are likely to be associated with. Mutual Fund investments are subject to market risk. 

Please read the offer document carefully before investing’ says the disclaimer in the every advertisement of the mutual fund. The objective of this disclaimer is to meet a statutory requirement which is basically intended to communicate the risks that mutual fund schemes have as an investment option. What are these market risks that the advertisement is talking about? 

Market risks are risks associated with equity investment, changes in the interest rates, foreign exchange risk and commodity related risk, if Basel guidelines are to be believed.  In context of mutual funds, these risks are little broader and include some risks such as default risk, reinvestment risks etc. Whatever be the nature of market risk, the disclaimer put in mutual fund advertisement raises a very obvious question. Are mutual fund investments subject to market risks alone? If so, for a given type of market risk prevailing in the economy, the performance of similar type of schemes of mutual funds should be almost similar. But that is not the case. Why does this happen? 

Let us examine this. More than market risks, fund manager and his approach matters: One of the key aspects of mutual fund performance is the role of fund manager and the capability that fund manager along with his team has. Market risks do exist in all investments but the key issue is how a fund manager mitigates these risks without significantly impacting the performance of the scheme of a fund. So the role of the fund manager is extremely critical. Right from selecting the stocks that will deliver to diversifying the schemes, mutual fund manager does the act of balancing risk versus return. The fund manager can reduce market risks if not completely eliminate it. Such is the influence of fund manager that some schemes are identified with them. Fund managers capabilities also influence the inflow and outflow of investments of money in a scheme.

 Unfortunately reading offer document does not convey this aspect of fund manager’s capability as it gets pronounced only after specific period of performance. So how will an investor select the right fun manager especially in case of in existing fund? There are some basic checks. Look at how many funds are being managed by a fund manager. All the mutual funds publish a fact sheet or an information document carrying details of the funds and the fund managers. The fund managers are also subject to continuous media scrutiny. So an investor can also identify a good fund manager from such details. It is equally important to see the size of fund managed by a fund manager. 

This will decide the performance of a mutual fund. It has often been found that a fund manager managing a very large size fund looses direction and the performance of the fund falters. Another critical factor is to determine the fund manager’s strategy would come from churning of portfolio. The more frequent the churning, the higher will be cost. This needs to be watched specifically. Competition kills in mutual fund business: There are around 300 schemes of equity mutual funds in India and there are barely 500 good companies listed on the stock exchange. 

How will these schemes differentiate themselves? Mutual fund schemes, especially equity schemes are operating in a cut throat world. How will a fund house differentiate its schemes from schemes of other fund houses? Some fund houses have the issue of differentiating various schemes of their own fund house. It is not surprising that some of the schemes have failed to perform because they could not manage required corpus meant to run the schemes. Some ill timed and ill thought of schemes failed to take off. There were no market risks in these funds but for investors these schemes worked out to be nightmare. 

As a rational investor one should not ignore key aspects of mutual fund investments like those mentioned above. Mutual fund investments are indeed subject to market risks but not just market risks. The person running the show has equal importance if not more than market risk.

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