While there are many different ways to differentiate mutual funds, one of the most popular ways is to do it as per their market risk. Read this post to what market risk is and how it can be used to differentiate different funds.
“Mutual funds are subject to market risk”- you might have already seen or heard this one-liner in each of the mutual fund advertisements. Mutual fund investments involve many different types of risks, like credit risk, liquidity risk, inflation risk, currency risk, and interest rate risk. However, not every type of risk is associated with every type of fund.
Out of these, the market risk is one of the most important and applies to any fund you select. These are unavoidable risks which can affect the whole market. As the market risk is something that applies to every mutual fund, it can also be used for differentiating different types of funds as the risk varies significantly between various funds.
Let us have a look at different types of funds as per their market risk-
- Equity Funds
The equity market or the stock market is quite famous for its volatility. While equity funds are an excellent option for people who do not want to invest their money in the market directly, the equity funds still carry the highest amount of risk. But they can also generate the highest returns as compared to other funds.
As these funds invest your money in the stock market, the fluctuations of the market have a direct impact on your investment. Equity funds are further divided into large-cap, mid-cap, and small-cap funds. Among these, the small-cap funds have the highest amount of risk followed by mid-cap and then large-cap funds.
Risk Level: Moderate to High
- Debt funds
Debt funds invest your money in instruments like government bonds, company debentures, and a host of other fixed-income instruments. The market risks associated with debt funds is considerably lower than equity funds. However, the returns are not as impressive as equity funds.
These funds are preferred by investors who want to generate returns better than FDs and are looking for regular income and capital protection. But contrary to popular beliefs, debt funds are not 100% risk-free.
Risk Level: Low to Moderate
- Balanced or Hybrid Funds
Balanced funds are a combination of equity and debt investments. A fund can be equity-based with the majority of the investment in equity or debt-based with most of the portfolio having debt instruments.
An equity-based balanced fund would carry a higher level of risk as compared to a debt-based fund. However, the risk is not as high as a pure equity fund as there is a cushion of debt in the portfolio. Generally, these funds are known to offer a healthy combination of safety and appreciation.
Risk Level: Moderate to Moderately High
- ELSS Funds
ELSS funds are also diversified equity funds which are used for tax-saving. They have a lock-in period of 3 years which is shorter than most popular tax saving instruments. But as they are equity-based funds, they carry a healthy amount of risk too.
However, their lock-in period of 3 years helps investors generate positive returns in most cases as equity investments tend to perform better on a long-term basis.
Risk Level: Moderately High
- Money Market Funds
The money market funds are funds that invest your money in highly liquid instruments like treasury bills, commercial papers, and bank certificates.
These funds are known to be the safest types of mutual funds and allow investors to save their principal while also generating moderate returns.
Risk Level: Low
None of the mutual funds are 100% risk-free, making it very important for every investor to have a clear knowledge of the risks involved. Based on the information above, depending on your risk appetite you can now make an informed investment decision.