Every mutual fund carries some level of risk. However, not all mutual funds are exposed to the same type of risk. Understanding these risks helps investors select the right scheme according to their investment objectives and risk appetite.
This article explains the major risks associated with mutual funds and identifies the fund categories most affected by each risk.
Major Risks in Mutual Funds
| Risk | Meaning | Mainly Affects |
|---|---|---|
| Market Risk | Risk of loss due to a fall in the overall stock market. | Equity Funds |
| Interest Rate Risk | Risk that bond prices will fluctuate because of changes in interest rates. | Gilt Funds, Debt Funds |
| Credit Risk | Risk that the issuer's financial strength deteriorates or defaults on its obligations. | Credit Risk Funds |
| Default Risk | Risk that the issuer fails to pay interest or principal on time. | Corporate Bond Funds |
| Liquidity Risk | Risk of not being able to sell securities quickly at a fair price. | Small Cap Funds, Debt Funds |
| Concentration Risk | Risk arising from excessive exposure to a single company, sector, or industry. | Sectoral and Thematic Funds |
| Currency Risk | Risk due to fluctuations in foreign exchange rates. | International Funds |
| Inflation Risk | Risk that investment returns fail to keep pace with inflation. | All Investments |
| Reinvestment Risk | Risk of reinvesting interest or maturity proceeds at lower interest rates. | Debt Funds |
| Duration Risk | Risk that long-duration bonds are highly sensitive to interest rate movements. | Long Duration Funds, Gilt Funds |
Which Mutual Fund is Most Affected by Which Risk?
| Fund Category | Most Important Risk |
|---|---|
| Equity Fund | Market Risk |
| Large Cap Fund | Market Risk |
| Mid Cap Fund | Market Risk |
| Small Cap Fund | Market Risk and Liquidity Risk |
| Sectoral/Thematic Fund | Concentration Risk |
| Index Fund / ETF | Market Risk |
| ELSS Fund | Market Risk |
| Hybrid Fund | Market Risk and Interest Rate Risk |
| Corporate Bond Fund | Credit Risk and Default Risk |
| Credit Risk Fund | Credit Risk |
| Banking & PSU Debt Fund | Interest Rate Risk |
| Short Duration Fund | Interest Rate Risk |
| Long Duration Fund | Duration Risk and Interest Rate Risk |
| Dynamic Bond Fund | Interest Rate Risk |
| Gilt Fund | Interest Rate Risk |
| International Fund | Currency Risk |
| Liquid Fund | Very Low Credit Risk and Very Low Interest Rate Risk |
| Overnight Fund | Negligible Interest Rate Risk and Credit Risk |
Understanding Each Risk in Simple Words
1. Market Risk
This is the risk of losing money because the overall stock market falls.
Example: If the Sensex or Nifty declines sharply, most equity mutual funds will also fall.
2. Interest Rate Risk
When interest rates rise, bond prices generally fall. Debt mutual funds that invest in bonds are affected by this risk.
Highest in: Gilt Funds and Long Duration Funds.
3. Credit Risk
This is the risk that the company issuing the bond may experience financial difficulties, leading to a downgrade in its credit rating or even default.
Highest in: Credit Risk Funds.
4. Default Risk
Default risk occurs when the issuer actually fails to pay interest or repay the principal amount on the due date.
Highest in: Corporate Bond Funds.
5. Liquidity Risk
This is the risk that a security cannot be sold quickly without affecting its price.
Highest in: Small Cap Funds and certain Debt Funds.
6. Concentration Risk
A fund that invests heavily in one sector or a few companies is exposed to concentration risk.
Highest in: Sectoral and Thematic Funds.
7. Currency Risk
International mutual funds are affected by fluctuations in foreign exchange rates.
Highest in: International Funds.
8. Inflation Risk
If the return on an investment is lower than the inflation rate, the investor loses purchasing power.
Applies to: All investments.
9. Reinvestment Risk
Interest or maturity proceeds may have to be reinvested at lower interest rates, reducing future returns.
Highest in: Debt Funds.
10. Duration Risk
Long-term bonds experience greater price fluctuations when interest rates change.
Highest in: Long Duration Funds and Gilt Funds.
