Mutual Funds:

Sizing up All Your Risks
By Shiv N. Majumdar

All of us are aware that our deposits in a bank in India are insured/ guaranteed up to Rs 1 lac per bank (not branch). A bank's ad calling for deposit does not carry this warning. Insurance ads have a mandatory sentence, which just reads, as "Insurance is the subject matter of solicitation" which does not really communicate much. But, a mutual fund scheme ad will carry the following repulsive mandatory sentences:

"Mutual funds and security investments are subject to market risks and there is no assurance or guarantee that the objectives of the Schemes will be achieved.

As with any security investments, the NAV of the units issued under the scheme can go up or down depending on the factors and forces affecting the capital markets.

Past performance of the Sponsors, the Asset Management Company or the Fund does not indicate the future performance of the Schemes of the Fund.

XYZ is the name of the scheme and does not in any manner indicate either the quality of the scheme or its future prospects and returns

The Sponsors are not responsible or liable for any loss resulting from operations of the scheme beyond the initial contribution of Rs 1 lakh (or more as applicable) made by it in setting up the Fund."

That investors ignore these words or do not care about them is another matter. Much like the statutory warning on cigarette packs: "Cigarette smoking is injurious to health".
However, a meticulous investor will most positively be put off by these warnings. They are well meaning, but inadequately worded and also totally out of context.

We must first evaluate these risk factors. We would like you to refer to the statutory sentences above, as we discuss them.

What are market risks? These are risks common to all items and transactions in a market. For example, the risk of a reduction in values in the event of a war. Most investors would read much more risks in the first statutory sentence.

Let us consider the third sentence. How do you judge the prospects of your investments? Surely by basing on some solid facts for forming an opinion. Sponsor, AMC and Fund Manager are the source of your money management results. If only market could give you results, then you could have handled yourself. If not past performance, what else can give you the basis of your opinion about what to expect from these people? It is most certainly an indicator of future performance. It certainly is not a sure indicator or a guarantee of future performance or results.

Apart from these observations, all these sentences together are doing the investors a disservice by raising an undue scare about mutual fund investing.

Now let us consider the other factors not covered by the statutory warnings.

Fund size:
Too small funds are inefficient. If fund size is not big enough, sudden pressure of redemptions may adversely affect it.

Debt-equity allocation:
Over a period this allocation is a crucial determinant of your results and hence the risk of varying results. If you are over-exposed to equity when the market is falling, it will bite you. But, in a rising market if you are under-exposed to equity you will gain less.

Diversification/ concentration risks:
If all eggs are put in one basket your risks will be high. Therefore your fund scheme needs to diversify or put eggs in different baskets. You can find out how many assets the corpus is spread over or the number of companies in the portfolio. However, if your money is spread thinly over too many items your results will suffer. So the level of concentration is also important. There must be balance in this regard.

The nature of investment picks:
Is your fund manager meddling in new issues? They carry a little higher risk. Is he picking companies with small business size and market capitalisation? MICO will carry lower risks than Subros Ltd though both may be from the same auto ancillary industry. Risk level would also rise if your fund manager picks midcaps as opposed to market leaders.

Fund manager's tendency to play to galleries:
Fund managers are human. Market frenzies also affect them. Moreover, publicly available short-term results make people expect visible short-term results in judging them. They get forced to play to galleries to avoid large redemptions in open-ended funds. These short-term actions mostly are harmful for long run results. Also short term results involve taking higher short term risks.

Record in trusteeship:
Your fund manager is the trustee of your funds. His actions should not be prejudicial to your interests. Alliance Mutual Fund and Samir Arora are accused of this deficiency only. If watchful, investors would be able to find out how a fund caries its trusteeship responsibilities.