If you scroll through any mutual fund website, and you will find a lot of data about how a particular fund or scheme of the AMC has outperformed the market. There could be an analysis of how the particular fund has beaten the market index. There could also be a comparison between a particular fund and the other funds in the category to highlight the superiority of a particular fund. There could be an elegant table or chart which outlines how that particular fund could have created wealth for an investor over a period of time. As a smart investor, it is your job to conduct 6 basic tests before deciding on buying a mutual fund.
- Diversification is the key to risk management
- Managing risk through better stock selection
- Managing risk through adjustment of duration
- Managing risk through asset allocation
Diversification is the key to risk management
Diversification is one of the core advantages of investing in mutual fund. When your money is spread across stocks with low correlation, your overall portfolio is not overly exposed to a few events. Let us assume that you create a portfolio consisting predominantly of banks, real estate companies and auto companies. The problem is that all these three sectors are rate sensitive,which means they perform well in a falling interest rate scenario but underperform in a rising interest rate scenario. If RBI hikes repo rates then your entire portfolio will suffer. That is because all the three sectors will be adversely impacted by the rate hike. In short you run the risk of concentration in your portfolio.
Mutual funds overcome this problem by spreading your portfolio across multiple stocks with low or negative correlation. This will ensure that your portfolio is not over-exposed to negative implications of a couple of factors. This is a key technique of managing portfolio risk.
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Managing risk through better stock selection
This is another way by which mutual funds manage to reduce risk in your portfolio. Most mutual funds have experienced fund managers who are backed by a team of analysts and traders. This ensures two things - firstly, it ensures that there is a lot of in-depth analysis that goes in before buying or selling a stock. Not only are the fundamental and technical trends of the stock studied, but its correlation with the existing portfolio is also evaluated. Secondly, the dealer ensures that you get the best price in the market and purchases are phased in a manner as to get the best price. In addition, mutual funds have a process of continuous monitoring of the portfolio. Your existing portfolio is constantly evaluated by a team of experts to evaluate the impact of domestic macro factors, global macro factors, industry specific factors and company level factors on the performance of these companies. These substantially reduce the risk of the portfolio.
Managing risk through adjustment of duration
This is a slightly more aggressive strategy that is applied to the bond portfolios and to bond funds. Every bond has a term to maturity, but then interest payments during the tenure of the bond ensure that the duration of the bond is lower than the term to maturity of the bond. Fund managers constantly move the portfolio across the duration curve. For example; if the view on interest rates is that it will go down then fund managers will move to longer duration bonds so that the benefits of capital appreciation can be better captured. The reverse is true in case their view is that interest rates will go up. The biggest problem that individuals face when they invest in debt securities is that they do not have the ability to adjust duration accordingly. Hence, mutual funds help to avoid a lot of risks.
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Managing risk through asset allocation
An interesting method of eliminating risk is through asset allocation. One can do asset allocation based on a variety of parameters like age, risk appetite, view on interest rates and P/E ratios etc. There are dedicated allocation funds that define rules based on which allocation between equity and debt is shifted. These allocation funds try to get into equities and debt at the right time so that the risk of being in the wrong asset at the wrong time is obviated. While the fund takes a generic decision and cannot cater to the requirements of individuals, the investors have a broad palate to choose from. An allocation fund also has the leeway to sit on cash waiting for better opportunities in the market.
Risk mitigation is, therefore, a key role played by mutual funds. Not only are the funds professionally managed, but they also use aggressive strategies to mitigate potential risk. But above all, the benefit of diversification is a major benefit offered by mutual funds and for individuals looking to participate in investments, this is a great benefit.