Risks inherent in mutual funds
Although it is unlikely that one is going to lose every single cent when investing in mutual funds, unlike complicated structured products, a person can still sustain heavy losses that almost never recover. Just ask those who invest in technology funds during the dot com bubble. As with any other investments, risks is curial to consider even for mutual funds – an investment vehicle with so called diversified in many different companies’ stocks and bonds. The following points are needed to take note regarding risks of pooled investments like mutual funds.
The risks for mutual funds is different from the risks from investing in individual stocks, the former is more of market risk while the latter is more of individual company risk.
Knowing the following categories of risk is essential in the sense that we are all human beings and driven by two emotions then it comes to money, namely fear and greed. There will always be bear market from time to time, and bull market as well. As a result, it is not so easy to tell yourself that when a $10 000 investment reduces to $680; it is just paper losses as long as you don’t cash out. As usually, these paper losses translate into great fear and many sleepless nights until finally sell it out, afraid that things will get worse, paper losses are turned into actual losses.
Even institutional investors like Sovereign wealth funds got buy at the top and sell at the bottom, and got one happen all the time, which by right should not have happened as they are supposed to have the resources to hire top talents with first class honors degrees from renowned colleges around the world, though it is most probably because of them turning to an army of yes man like the case for Lehman Brothers.
In other words, it is hard to be rational when things don’t look good, especially when it comes to hard earned money. In general, a fund that generates larger returns in a short time can also at the same time incur larger losses. Again, the perfect example is funds that invest heavily in Internet companies during and after the dot com bubble.
1. Sector Risk
There are many sectors in our economy. To give a few examples, they are, including but not limited to, health care, consumer goods, financial, energy, utilities, technology, telecommunications and media etc. There mutual funds that focus on only one sector, like financial, and get burned heavily during the 2008 economic crisis, or those that invest mainly in technology stocks, also got burned when the dot com bubble burst, regardless of how skilful the fund managers is or how many As he or she get during colleges or how many percent you pay for their management fees.
For those funds that are not sector specific, they may also be vulnerable to sector risk as mentioned above if a significant percentage of fund’s weightings are in one sector. Knowing about sector risk does not mean you don’t invest in funds that skewed towards one sector or with large weightings in one sector but to be aware of not buying another fund that also only contain stocks in the same sector as this will increase risks when you can increase expected returns without the added risks by simply placing investment dollars in other sectors.
2. Past volatility is predictive of future volatility
There is a common saying in investment arena that past returns do not equal future results. There is a less well known fact in investing that past volatility is equal to future volatility. This is in addition to checking the fund’s weightings in which sectors and whether there are significant holdings in some individual stocks. In fact, the past volatility of a fund and even individual stocks can accurately indicate its future volatility also.
3. Knowing your threshold of losses
As a consequence of the above, the worse losses sustained by the fund in the past may most probably be its worst losses in the future also, touch your heart and ask yourself, if you can still hold on to the fund during its worst period. If can, then it is wise to buy into the fund, if not, there is a good chance that you are going to realise your paper losses in future since past volatility is almost equal to future volatility also.
To have a rough and accurate gauge of future losses, one can simply look at its worst historical period and imagine if you can hold on to that amount of losses.
4. Company specific risk
Other than sector risk, there is one other important risk that mutual funds have. There are now much more mutual funds in the market than the total number of stocks. Some is really diversified into hundreds of different of stocks while some hold only between 20 to 30 stocks. One thing to note is that almost every fund manager does not spread all the fund’s investment dollars equally across all the different companies, if there is a fund that does that and charges you 2% per year in management fee, there is most probably only high school graduates doing simple administrative work for the fund simply because you don’t need to pay some fellers 2% per year if they do nothing other than divide the dollars equally across all investments. I think any school kids know how to do average.
As such, it is essential to check a mutual fund top 10 companies and find out how much of a fund’s assets are invested in there. Please be aware that even if a fund got more than 100 different companies’ stocks, there could still be high volatility if near to 50% of fund’s assets are concentrated in 10 or less holdings. All else being equal, that funds will of course be more volatile than another one with same number of holdings but less concentration on a few holdings.
5. Standard deviation as a measure of risk
More than an academic interest, standard deviation has practical uses in a real life investing world. Intuitively, standard deviation is a qualitative measure of a fund’s returns fluctuation around the mean during a chosen time period and the mean is defined as the average annual return for that time period. To give an example, if a large cap growth fund had a mean of 8.80% and a standard deviation of 20.63% for a five years period, it tells you that for 60% of the time, the fund annualized return was plus and minus 20.63% of 8.80%.
As with returns, one doesn’t look at standard deviation in isolation. You need to compare it with a benchmark index or funds in the same category groups. A rational investor should not choose to invest in a large cap fund with a mixture of value and growth if its standard deviation is significantly higher than the S&P500 and if the returns are not any higher than the S&P500. The S&P500 index is a standard benchmark for large cap funds and a higher standard deviation than the index means that you are not equally compensated for the volatility it brings if the returns are around the same.
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