Which mutual funds are risky and why should you avoid investing in those mutual funds?

Risky mutual funds to avoid!

If you are an investor, then you must have come across the popular saying “high risk equals high returns”. In simpler words, this means that if the risk in an investment or an instrument is high, then the returns would be high as well. This is also applicable in the case of mutual funds. Here you have to understand that different mutual funds work differently. Hence, there are certain funds that usually yield higher returns when compared to other similar funds, but they also entail greater risks. But retail investors are generally advised to avoid these mutual funds because although the higher risk may bring higher returns at times, it is not always the same for all cases. Thus, you may invest in quite a risky fund and hardly have any significant returns.

As we already mentioned, some mutual funds carry higher risk when compared to their peers, so investors must be careful before investing in such funds. Let us now look at some of the mutual funds of this category that are quite risky in nature.

Related: Focused funds Vs Diversified Mutual Funds: Which one to choose?

Risky Mutual Funds

Thematic Funds and Sectoral Funds - A sectoral fund is basically an equity fund that invests at least 80% of its corpus in various companies that belong to the same industry or sector. Let’s take an example to make things easier for you to understand. Following the criterion above, technology funds would invest at least 80% of their assets in technology companies as they belong to the same sector. This indicates that whether the investment would be successful totally depends upon how well the stocks in that sector would perform. Since the investment is made only in companies belonging to the same sector, the investment portfolio is less diversified. This is what makes sectoral funds much riskier, with the returns dependent solely upon the performance of certain companies as the portfolio is not diversified. 

In a similar manner, thematic funds are also mutual funds that invest in assets belonging to a particular theme, for example, healthcare. This makes thematic funds as risky as sectoral funds due to a lack of diversification. It is always wise to stick to diversified equity funds.

1. Small-cap funds - Small-cap funds have usually been found to grow faster than large or mid-cap funds. This might lure you to invest in small-cap funds, but you must keep in mind that, in this case, consistency plays a huge role. Small-cap funds may have a faster growth rate, but they suffer equally during market downturns. So, if you are investing for the short term, small-cap funds might be a risky bet.
    
2. Credit risk funds- These funds buy papers with a significant chance of losing the principal. They are required by mandate to invest at least 65% of their assets in securities that do not really have the highest ratings. The highest-rated funds have a credit rating of AAA, while credit risk funds are allowed to invest in AA-rated funds at best. These bonds are bought by the managers of the fund as they have higher coupon rates that yield higher returns for the investors. However, this might not always be the case, and thus, things may not go as planned by the fun management. 
    
3. Long-duration funds- These funds are required to invest in securities that have a maturity period of a minimum of 7 years. The price of such long-term funds is more vulnerable to changes in the rate of interest. Consequently, the value of bonds decreases with the increase in the rate of interest and thus results in a negative NAV. These funds provide quite high returns when the interest rate decreases but get hit quite harder than short-term funds when the rate of interest increases. Thus, it is better for retail investors to opt for target maturity funds instead. 

Related: Dummies Guide to mutual funds

How to mitigate the risk?

If you still want to invest in these funds, you should allocate only a small part of your portfolio. A major chunk of your portfolio should be in diversified multi-cap funds and some part of your portfolio can be in small-cap funds, credit risk funds and long-duration funds. 

Also Read: Different types of funds available under mutual funds

8 Mutual Funds You Should Never Buy

Disclaimer: This article is intended for general information purposes only and should not be construed as investment or legal advice. You should separately obtain independent advice when making decisions in these areas.