Mutual Funds Day 41: Mutual Fund investments are subject to market risks, read all scheme related…
“Mutual Fund investments are subject to market risks, read all scheme related documents carefully” You might have heard this disclaimer, but let me tell you — it is not what you think.
People usually think Market risk means the general drop in stock prices, i.e. the risk that the stock you bought for 500 is now quoting for 400. Instead, market risk is when events impact the entire country or ecosystem all at once. The risks that are facing the capital markets are broadly divided into market risks and diversifiable risks. The technical name of market risk is called systematic risk. The technical name for diversifiable risk is unsystematic risk.
Let us discuss these two risks in detail
- Systematic Risk (market risk).
- Unsystematic Risk (diversifiable risk).
Systematic risks are events that impact the entire ecosystem like:-
- Inflation
- Interest Rate changes
- Exchange Rates changes
- Terrorist activities
- Natural calamities
No matter what the fund manager does, systematic risks cannot be avoided to an extent. These events impact the entire ecosystem and they cannot be predicted, controlled, or mitigated. When such a risk occurs, the mutual fund manager or AMCs may not be able to handle it hence the disclaimer. The investor may end up facing a capital loss and the fund manager would not be able to quantify the extent of the loss or the time required to recover the same.
Unsystematic risk on the other hand means issues that are specific to a firm, industry, sector, or region. Mutual funds can handle unsystematic risks by diversifying i.e. by buying a basket of stocks from unrelated sectors so that even if one sector goes down, its impact on the total portfolio would be less.
Examples of unsystematic risks would be
- Bankruptcy of a firm, business risk.
- Fraud at a firm level or industry level
- Legal risk for a firm, industry, or sector
- Operational risk for a firm, industry, or sector
The disclaimer “MFs are subject to market risks…”, means that the systematic risks cannot be handled whereas the unsystematic risks will be taken care of. The drop in stock prices is not a risk per se, it is part of the game. Stocks are expected to be volatile and the prices could go up or down. The risk of a stock going down is not a market risk; hence the mutual fund house is not bothered to an extent.
If the fall of the stock prices continues, it could be an unsystematic risk affecting the firm. The mutual fund house will exit the stock position and replace it with a winner. Yes, your mutual fund holding will notice a dip, but it will recover with time. This step is called rebalancing.
“Please read the scheme related documents carefully…” is the second part of the disclaimer. Every mutual fund comes with a scheme information document (SID) and Statement of Additional Information (SAI). The AMCs and mutual fund houses are asking you to read those documents as it gives you an idea of how risky the investments could be.
To view a sample of the SID of the SBI Nifty Index fund, click here.
By reading through the document, you will get a fair idea of how the AMC handles unsystematic risks. For example, if Infosys runs into some trouble, then you can assess the damage as it has a 6.72% weightage. Similarly, if the automobile and auto component sector has a problem, you can quickly identify that the impact could be limited to 5.31% of the total fund value (approx).
Even if these 2 bad actors keep underperforming, I am quite sure the SBI fund house will start their risk mitigation activity by rebalancing.
In the case of a sectoral or concentrated mutual fund, eg: an IT sector fund, all its holdings will be IT companies. Sectoral funds are not that diversified and are prone to unsystematic risks too.
It may take a while for you to understand and select safer mutual funds from the entire investing universe, it is like finding a needle in a haystack. A professionally qualified advisor/distributor may be able to guide you for the same.
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