A mutual fund is a professionally managed company that collects money from many investors and invests it in securities such as stocks, bonds and short-term debt, equity or bond funds and money market funds.
Mutual funds are a good investment for investors looking to diversify their portfolio. Instead of betting everything on one company or sector, a mutual fund invests in different stocks to try to minimize portfolio risk.
The term is typically used in the US, Canada and India, while similar structures around the world include the SICAV in Europe and the open-ended investment firm in the UK.
Understanding risk in mutual funds
You lent 5 euros to your friend who has an initial interest @8% (higher than the current bank rate of 7%). Even if you’ve known him for years, you still run the risk that he won’t return your money on time or can’t pay back. Also, the bank rate could rise to 8.5% while you are stuck with 8%.
Similarly, debt funds invest your money in interest-bearing securities such as bonds and money market instruments. These securities promise to make regular interest payments to these funds. So debt funds are subject to three big risks like you when lending money to friends.
- First, because these funds invest in interest-bearing securities, their NAV fluctuates with interest rate developments (interest rate risk). The prices of these funds fall when interest rates rise and vice versa.
- Second, these funds are subject to credit risk, i.e. the risk of not receiving regular payments from the underlying securities (e.g. bonds) in which they have invested.
- In the worst case, these funds can face the risk of default when the bond issuer does not make the promised payment. When a bond in the underlying portfolio of a debt fund defaults on its payments, this affects the interest income component of the fund, thereby negatively affecting the total return from the fund.
