General and Specific Risk Factors

Risk Factors Affecting Mutual Fund Performance

Mutual Funds and Risk Factors:

• Subject to Risks: Mutual funds are subjected to various risk factors that can impact their performance.

1) General Risk Factors:

• Definition: These risks affect the overall financial market and can impact all types of mutual funds, regardless of their investment objective or asset class.
• Types of General Risk Factors:
  • Market Risk (Systematic Risk):
    • Description: Changes in stock or bond prices due to broad market movements caused by economic, political, or social events. This risk is undiversifiable.
    • Examples: Stock market crash, geopolitical tensions, changes in economic policy, global recessions.
  • Interest Rate Risk:
    • Description: Fluctuations in interest rates, primarily affecting debt funds.
    • Impact: Inverse relationship between interest rates and bond prices. Rising rates generally decrease bond values, especially for longer-duration bonds.
  • Inflation Risk:
    • Description: The risk that inflation erodes the purchasing power of returns.
    • Impact: Returns may not keep pace with inflation, resulting in a lower real return, especially for fixed-income investments.
    • Negative Real Return: If inflation exceeds the nominal return, the real return is negative.
  • Liquidity Risk:
    • Description: The risk of not being able to sell securities at a fair price when needed due to low trading volumes or market disruptions.
    • Impact: Can lead to losses if forced to sell at unfavorable prices.
    • Example: Small-cap equity funds or funds holding less liquid debt instruments may face liquidity issues during market stress.
  • Credit Risk (Default Risk):
    • Description: The risk that issuers of bonds or debt instruments may default on interest or principal payments.
    • Impact: Primarily affects debt and hybrid funds. A downgrade in a bond's credit rating can lead to a decline in its price.
  • Currency Risk (Exchange Rate Risk):
    • Description: Applicable to international funds investing in foreign securities. Fluctuations in exchange rates can affect returns for domestic investors.
    • Example: Depreciation of INR against USD may decrease returns for Indian investors in US equity funds.
  • Regulatory Risk:
    • Description: Changes in government policies, tax laws, or regulations can impact mutual fund performance.
    • Examples: Changes in capital gains tax rules, SEBI regulations on expense ratios, etc.

2) Specific Risk Factors (Unsystematic Risk):

• Definition: These risks are unique to a particular company, sector, or asset class and can be reduced through diversification.
• Types of Specific Risk Factors:
  • Equity Fund Risks:
    • Stock Selection Risk: The risk of poor stock selection by the fund manager, leading to underperformance compared to the benchmark.
    • Sector Risk: Concentration in a particular sector (e.g., technology, healthcare) can increase volatility and impact performance if that sector underperforms.
  • Debt Fund Risks:
    • Credit Risk: (Already mentioned as a general risk, but also specific to individual debt issuers within a debt fund portfolio)
    • Duration Risk: The sensitivity of a debt fund's NAV to changes in interest rates. Funds with longer duration are more sensitive.
    • Reinvestment Risk: The risk that when interest rates fall, the proceeds from maturing bonds or coupon payments will be reinvested at lower rates.
  • Hybrid Fund Risks:
    • Combines Risks of Equity and Debt: Hybrid funds carry a combination of risks from both equity and debt components.
    • Asset Allocation Risk: Incorrect asset allocation strategy (e.g., wrong equity-debt mix) may lead to suboptimal returns.
  • Sector and Thematic Fund Risks:
    • Concentration Risk: Highly concentrated in a specific sector or theme, making them more risky.