Risk is an unavoidable part of investing. While different investments may fall on different points across the risk spectrum, there is hardly any investment that's entirely risk-free. Mutual funds also carry risk. But first, what is 'risk' exactly? In the world of investing, risk is the other name for volatility or fluctuation in price. An investment that is susceptible to wild swings in either direction is considered to be highly risky. Both equity funds and debt funds carry risk, but debt funds are generally not as risky as equity funds. Equity tends to be volatile, especially in the short to medium term.
In order to judge the inherent risk in mutual funds, the most basic tool is the riskometer. All mutual fund schemes carry a riskometer which points at the inherent risk in the scheme.
More specifically, here is how various categories of equity funds stand in the increasing order of their risk grade:
Aggressive hybrid funds are the least risky as they can invest as much as 35 per cent of their assets in debt. Since large companies don't fluctuate wildly, they come next. Mid and small caps are notorious for their crazy moves, so the funds investing in them appear at the second last position. Finally, since thematic and sectoral funds take highly theme-specific bets, they are the riskiest of all.
Here is how debt funds stand in the increasing order of their risk grade:
Liquid funds < Ultra short-duration funds < Short-duration funds < Medium-duration funds, Credit-risk funds, Dynamic-bond funds, Long-term gilt funds
With debt funds, the risk is two-fold: interest risk and credit risk. Interest risk means that interest rates may move up or down unexpectedly. A rise in interest rates results in a decline in bond prices and vice-versa. So a fund that holds long-duration bonds is subject to high risk. Credit risk is the risk of default by the bond issuer. Debt funds that invest in relatively lower-rated paper carry this risk.
There are other risks also in mutual funds which the investor can minimise by making prudent decisions. By investing across multiple fund houses and schemes, one can reduce fund-house-specific, fund-manager specific and scheme-specific risk. Also, by sticking to multi-cap equity funds one can reduce portfolio risk.
Value Research has risk-adjusted ratings for mutual funds. While calculating these ratings, we assess the balance between risk and return. Using these ratings can help you get optimum results for the risk taken.