“High risk means high returns.” If you are an investor, you must have come across this adage quite often. It basically means that if an instrument is offering a high return, it is quite possible that it carries a high risk as well. The same is true in the case of mutual funds as well. Different mutual funds have different risk-return profiles. There are certain categories of funds which may deliver higher returns when compared to other categories. But they also carry a higher degree of risk as well. Now, since the higher risk doesn’t commensurate with the kind of returns that they deliver, you are better off avoiding these risky mutual fund categories.
In this blog, we will tell you about some of the mutual fund categories which carry higher risk compared to others. As the risk level is higher, retail investors should be watchful when investing in funds in any of these categories.
1. Thematic Funds And Sectoral Funds
A Sectoral Fund is an equity fund that invests at least 80% of its corpus in businesses belonging to the same sector.For instance, technology funds will invest 80% of the assets in technology companies like Infosys, TCS etc. This increases the risk in the portfolio as it will be less diversified. The performance of the funds will depend on the performance of the stocks in that particular sector.
Similarly, Thematic Funds are equity mutual funds that invest in stocks tied to a theme. At times, the theme can be very narrow, like healthcare, energy, etc. It means they are as risky as sectoral funds. On the other hand, some Thematic Funds follow broad themes like ESG, business cycle, etc. These are so broad that their portfolio is similar to any other diversified fund. And you don’t really offer anything unique. Overall, you are better off investing in diversified equity funds that invest across sectors and themes.
To gauge the possible volatility due to the narrow investment mandate in Sectoral and Thematic Funds, see the following table that shows how the top-performing sector keeps changing every year.
| Ranks Of Indices As Per Their Performances Over The Past 10 Years | ||||||||||
| Index | 2012 | 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 |
| NIFTY Auto | 5 | 4 | 3 | 4 | 3 | 8 | 10 | 10 | 7 | 7 |
| NIFTY Bank | 1 | 9 | 1 | 9 | 4 | 4 | 5 | 3 | 11 | 9 |
| NIFTY Energy | 10 | 6 | 10 | 5 | 2 | 5 | 6 | 5 | 8 | 5 |
| Nifty Financial Services | 3 | 8 | 2 | 7 | 5 | 3 | 3 | 2 | 10 | 8 |
| NIFTY FMCG | 4 | 3 | 7 | 2 | 6 | 9 | 2 | 8 | 4 | 11 |
| NIFTY Infra | 8 | 7 | 6 | 8 | 8 | 6 | 8 | 7 | 6 | 4 |
| NIFTY IT | 11 | 1 | 8 | 3 | 10 | 10 | 1 | 6 | 2 | 2 |
| NIFTY Metal | 9 | 10 | 11 | 11 | 1 | 2 | 9 | 11 | 3 | 1 |
| NIFTY Pharma | 6 | 2 | 4 | 1 | 11 | 11 | 7 | 9 | 1 | 10 |
| NIFTY Realty | 2 | 11 | 9 | 10 | 9 | 1 | 11 | 1 | 9 | 3 |
| NIFTY Service | 7 | 5 | 5 | 6 | 7 | 7 | 4 | 4 | 5 | 6 |
As you can see, the top performers are changing quite frequently. Not even a single Index has been on the top for a continuous period. Therefore, adding a Sectoral Fund increases the risk in the portfolio as your overall exposure to the sector may be higher than the risk tolerance level.
Also, data shows every sector will not do well every year. Therefore, Sectoral Funds are generally used by investors for tactical allocation, that is, to benefit from a particular opportunity. So, you should know when to enter and exit the sector. If you don’t have the time and ability to do that, better to avoid Sectoral Funds.
And don’t worry about losing out on sectors that are performing well. Fund managers of diversified equity funds (Large cap, Mid cap, Flexi Cap, etc.) take positions in such sectors and stocks in their portfolio whenever they are expected to do well.
So, it’s better to stick to diversified equity funds.
2. Small Cap Funds
Smaller companies have the potential to grow at a faster pace when compared to mid and large-cap companies. This is the reason why you would see small caps stocks surge more during market rallies compared to large and mid-cap companies. But at the same time, they are likely to be hit harder during market downturns. That is why over the long term, they are unable to generate significant alpha over mid or large-cap stocks.
See the table below. It shows that the average 10-year rolling return of NIFTY Smallcap 250 TRI is lower than both NIFTY 50 TRI and NIFTY Midcap 150 TRI.
| 10-year rolling return over the past 10 years | ||||
| Benchmark | Max. | Min. | Median | Average |
| NIFTY 50 – TRI | 22.37 | 5.13 | 12.59 | 13.33 |
| NIFTY Midcap 150 – TRI | 23.30 | 7.27 | 14.22 | 14.64 |
| NIFTY Smallcap 250 – TRI | 20.19 | 2.53 | 11.73 | 11.85 |
Therefore, for retail investors, it may not make sense until and unless they know when to enter or exit a small cap. That is, it may make sense to take tactical positions in a Small Cap Fund. For that, you may need an advisor as it will be difficult for you to do so.
Therefore, when making your equity portfolio, keep a high allocation to large-cap focussed funds and invest partially in funds focused on mid-caps.
3. Credit Risk Funds
As the name suggests, these funds take credit risk. That is, they buy papers where the risk of loss of principal is high. Credit Risk Funds are mandated to invest at least 65% of net assets in papers that don’t have the highest credit ratings. These funds generally have a credit rating of AA or below, while the highest rating is AAA. The fund manager buys these bonds or debt papers as they offer higher coupon rates, which means better returns for investors. Moreover, in case the rating of the paper goes up, there are chances of capital appreciation as the bond price in which the mutual fund has invested will go up.
However, things may not work out as per the expectation of the fund manager. We saw that post the IL&FS crisis, many funds were hit hard due to defaults by companies due to the liquidity crunch. Some of the funds suffered huge losses.
The purpose of debt investment is to provide stability in the portfolio. You wouldn’t want to lose principal by investing in a debt instrument. Therefore, it is better to avoid this category.
Instead, you can keep money in shorter duration funds like liquid funds. If you are investing for the long term, you can also put money in the medium to short-term debt funds (for example, short-duration funds, corporate bond funds, banking and PSU bond funds).
4. Long Duration Funds
These funds are required to invest in debt papers with a maturity of at least 7 years. The prices of long-duration papers are more sensitive to interest rate changes. So, when interest rates go up, the prices of bonds held by these funds go down, resulting in a negative NAV.
This is something we are witnessing right now. As the Reserve Bank of India (RBI) has raised interest rates this year, the category average return of Long Duration funds is down around 2% this year to date (January to July).
These funds have also delivered double-digit returns during falling interest rates, but when the interest rate cycle turns, they are likely to get hit harder compared to those funds which are invested in shorter-duration papers. Therefore, investors need to time the entry and exit from these funds, which may not be possible for retail investors. Therefore, if you can’t do that, it is better to avoid funds in this category.
An alternative to long-term debt funds is target maturity funds. Target Maturity Funds are passive funds that invest in bonds based on the composition of the underlying index, such as NIFTY SDL or the NIFTY PSU bond. In Target Maturity Funds, there is a defined maturity as indicated in the scheme name and practice. These funds hold a collection of bonds that are constituents of the index they track with similar maturity dates, which are generally held until maturity. And, in theory, you are paid back your principal and earn interest along the way. However, like all mutual fund schemes, the principal is not guaranteed, which is a risk that investors need to factor in. But to reduce the interest rate risk, you will need to stay until the end of the tenure of such funds.
