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.
What kind of risks are investors exposed to in a mutual fund?
Mutual funds invest in securities that are traded in different markets, be they stocks, bonds, gold or other asset classes. Any tradable security is inherently exposed to market risk, i.e. the value of a security is subject to fluctuations caused by market movement.
Changes in the interest rate inversely affect the price of bonds and thus the NAVs of debt funds. Therefore, debt funds face the greatest interest rate risk. They are also exposed to credit risk (risk of default of the bond issuer). Some income-oriented debt funds are also exposed to inflation risk, meaning that the return they produce may not compensate for the inflation experienced by the investor.
Equity funds face market risk while investing in stocks that trade in the market, and fluctuations in stock prices affect the NAV of these funds.
Some securities are actively traded on the market while others are not. If a mutual fund has invested your money in securities that are not traded frequently, the fund may have difficulty buying or selling the security at the right time at an appropriate price. This is the liquidity risk that increases the cost of transactions within a fund’s portfolio, impacting your fund’s NAV.
Therefore, the risk of investing in mutual funds depends on the type of asset in which you invest.