In our previous blog ‘Understanding Different Types of Risks in Investing’ we had discussed what is meant by risk. The simple meaning of that is - deviation between actual returns and expected returns is called risk. Risk persists everywhere in investing. The only difference is the type and extent of that risk. Let’s understand the risk in equity funds.
Equity funds are considered to be high risk investments compared to other mutual funds types like debt funds and hybrid funds, etc. The reason being, equity funds look for growth in terms of capital appreciation and dividend income. The appreciation of capital may or may not happen and this uncertainty results in some kind of risk. It is important for investors to understand what are the different kinds of risks in different kinds of equity mutual funds.
Generic risk
The benchmark equity indices are considered to be the barometers of the economy. In other words, the equity markets (especially indices) seek to reflect the value in the real economy. And when indices fluctuate to reflect the economic scenario – it eventually results in some kinds of generic risks.
For instance, the real economy witnesses different cycles or waves known as peaks and troughs. From 2003 to 2008, the Indian economy was booming. The economy and the year 2009 turned gloomy. However, during 2010 an economic recovery was seen. Such cycles occur and they create ripples in the equity markets. The other such ripples have been the tech bubbles, recession after 9/11 attacks in the USA and even political policy paralysis. Geopolitical events or even a pandemic like Covid-19 are some kind of generic risks to the equity markets.
What happens is, in the long run, equity markets are a good barometer of the real economy. However, in the short run, markets can get over-optimistic or over-pessimistic, leading to spells of greed and fear. For instance, in March 2020 the Indian equity markets witnessed a significant decline in benchmark as well as all broader indices. But benchmark indices recovered immediately to make a new all time high in just next few months. Thus, while the equity markets in the long run look rational; short term volatility remains, resulting in risk. In other words, the returns from equity investments are not fixed or guaranteed. Hence, evaluation, selection and monitoring of sectors and companies are important to equity fund investing.
Portfolio specific or scheme specific risks
While we discussed the generic risk factors, let us discuss in detail what kinds of risk different types of equity funds carry.
Sector funds suffer from concentration risk. One would wonder and ask why? The reason is, the entire exposure is to a single sector. If that sector does poorly, then the scheme returns are seriously affected. Sector funds are considered to carry the highest risk among the equity mutual funds. To put it in a perspective the realty and infrastructure sectors witnessed a long lull after the financial meltdown in 2008. From 2004 to 2008 the realty and infrastructure sector had witnessed a strong bull run. Those who had invested heavily in such mutual funds schemes the long term underperformance would have been there. Every sector goes through the different highs and lows – and hence, it is advisable to take exposure only if one has got the risk capacity for the same.
Diversified equity funds, on the other hand, have exposure to multiple sectors and companies. Thus, even if a few sectors or companies perform poorly, other better performers can make up. Diversified equity funds are therefore less risky than sector funds. Usually, if overlapping of investment in equity is taken care of, by the fund managers, diversified equity schemes are a good investment option.
Under diversified equity schemes, some funds are launched as focused funds, which invest in a limited number of companies. The selection risk is high in such funds since a larger proportion of the fund’s assets is concentrated in each company and poor performance can have a significant impact on the scheme’s returns.
Thematic funds are a variation of sector funds. Here the investment is as per a theme, say infrastructure. Multiple sectors, such as power, transportation, cement, steel, contracting and real estate are connected to infrastructure. Thus, a thematic fund tends to have wider exposure than a sector fund, but a narrower exposure than a diversified fund. Therefore, thematic funds are less risky than sector funds, but riskier than diversified equity funds.
Mid cap mutual funds invest in mid cap stocks (top 101 till 250 stocks based on market capitalisation). These are usually less liquid and less researched in the market, compared to frontline stocks. Therefore, the liquidity risk is high in such portfolios. To put it in perspective, the volumes are lower and in many cases there are stringent circuit limits. Further, since they are intrinsically not as strong as the frontline stocks, they become riskier during periods of economic turmoil and many of them are liable to fail. These stocks see greater volatility in prices. And hence liquidity risk is higher in mid cap funds.
Contra funds take positions that are contrary to the market. Contrarian investors are those who take positions against the prevailing market trends. It is considered that while the equity markets in the long run are very rational, in short terms they may remain irrational. And hence, there is a mismatch in terms of intrinsic value and actual trading price of scrip. Here the contra funds try to take advantage of the price mismatch. In other words, it is a strategy where an investor buys stock which most others are selling and vice-versa. In this type of fund, the astute fund manager does deep market research to identify those underperforming stocks which have growth potential in the long run. However, this investment style runs a high risk of misjudgments.
Apart from this, the portfolio turnover also showcases some amount of risk. Portfolio turnover ratio is calculated as value of purchase and sale of securities during a period divided by the average size of net assets of the scheme during the period. A high portfolio turnover ratio relative to similar funds indicates an aggressively managed portfolio. This is a risky strategy with a short-term perspective.
Conclusion: Risk persists in all asset classes and equity investment is considered to be one of the most volatile one. Apart from the generic economic, political and geopolitical risk the micro risk factors also impact mutual funds returns. It is advisable to understand one’s own risk profile first and then invest in equity mutual funds schemes.
Pro tip: The equity markets can remain irrational longer than the investor can remain solvent. Even short term volatility may result in significant losses here. Understand the risk capacity and risk tolerance while investing in equity mutual funds.