Mutual Fund Risk

May affect mutual funds performance?

Investors are not always aware of mutual fund risk!

There is a perception that these funds are being managed by experienced professionals who have the time and experience to manage the funds in an expert fashion.

Also, mutual funds are generally perceived to achieve a level of diversification that the average investor is not capable of achieving.

This expertise and diversification may be seen to provide a safe bet.

However every type of investment, including mutual funds, involves risk. The possibility that you will lose money or fail to make money on an investment always exists.


How to Assess Mutual Fund Risk

In this discussion, I am referring to mutual funds that are mutual stock funds or managed share funds. That is, those mutual funds that are principally engaged in stock market investment.

There are a number of features of mutual funds that some investors might view as risks - such as ongoing costs, regardless of whether the returns are positive or negative.

And, depending on the timing of their investment, investors may also have to pay taxes on any capital gains distribution they receive — even if the fund performs poorly after they bought their units.

A fund's investment objective and its holdings are determining factors in determining how risky a fund is. The prospectus will generally help you to understand the risk associated with a particular fund.

Investors usually cannot ascertain the exact make-up of a fund's portfolio at any given time, nor can they directly influence which stocks the fund manager buys and sells, or the timing of those trades.

With an individual stock, you can obtain real-time information on prices with relative ease by checking your online stock brokers website. You can also monitor how a stock's price changes over short periods of time.

With a mutual fund, the price at which you purchase or redeem shares will typically depend on the fund's net asset value (NAV) or price per unit.

The fund might not calculate its NAV for some time after you've placed your order, but you should expect a calculation at least once every business day.

Different mutual fund categories have inherently different mutual fund risk characteristics and should not be compared side by side. Stock funds overall have a higher risk/return potential than bond funds. Hedge funds also have unique risks.

Stock funds face mutual fund risks based on the investments they hold.

A sector stock fund (which invests in a single industry, such as pharmaceuticals) is at risk that its price will decline due to developments in its industry.

A stock fund that invests across many industries is more protected from this industry risk.


Particular Mutual Fund Risk

Besides the usual risks that have to be considered when investing in the stock market, mutual stock funds have particular risks such as ...

• additional fees and expenses that do not usually occur when purchasing individual stocks directly
• the possibility that the manager of the fund strays from the investment approach advertised in the prospectus - manager risk
• excessive churning (buying and selling) of investments in the fund by the fund manager which may seriously affect the investors net returns by increasing capital gains tax
• funds are not insured or guaranteed by an agency of the government
• if a single stock increases dramatically in value your potential for a 'big win' is limited by the diversified nature of the fund
• diversification does not protect you from an overall decline in the market
• fees can obscure the returns you walk away with. Net return is the bottom line - an investment's true return after all costs (including tax) are deducted.

A prospectus will not contain all the costs that affect the net return on an investment. This is why it is important to compare net returns whether or not the fund is a no-load fund (one in which shares are sold without a commission or sales charge) or load fund (one that does have a sales charge or commission.


To Conclude

For an investor concerned about risk (which should be all of us), mutual funds comparison and mutual funds performance may provide some mutual fund risk insurance.

Mutual funds with a history of superior long-term performance may be a more suitable choice than the current 'high flyer' for the year.

Past performance provides no guarantee about future performance as last year's winner is often this year's loser.

Also choosing managers who have a value investing style will provide 'built in' risk insurance through the margin of safety that these investments should contain.

Websites such as Morningstar can provide valuable mutual funds ratings on categories of mutual funds and information on their performance. Morningstar also provides a mutual fund screener.

So if you are in the business of investing in mutual stock funds, the additional mutual fund risk that is inherent in these funds need to be carefully assessed.

Return from Mutual Fund Risk to Safe Investing

Return to Value Investing Home Page