Module 2 : Equity Funds
Risks you should be aware in equity investments
Any financial product whose value is derived from market price of underlying securities has risks associated with it. The nature and quantum of risk depends on the underlying asset class and investment strategy of the product. Among different asset classes, equity fund risk profile is higher compared to fixed income and gold. There are broadly two kinds of risks associated with equity investments – Systematic Risks and Unsystematic Risks. Please note that in this article we will discuss risk in equity investment that concerns mutual fund investors.
Risks you should be aware in equity investments
Any financial product whose value is derived from market price of underlying securities has risks associated with it. The nature and quantum of risk depends on the underlying asset class and investment strategy of the product. Among different asset classes, equity fund risk profile is higher compared to fixed income and gold. There are broadly two kinds of risks associated with equity investments – Systematic Risks and Unsystematic Risks. Please note that in this article we will discuss risk in equity investment that concerns mutual fund investors.
Systematic Risk
Systematic risk, also known as market risk, affects the entire market, not just individual stocks or sectors. They are caused by events which affect the entire economy, domestic or global. Examples of major market risk events in the last 20 years or so are, 9/11 attack in New York City, Global Financial Crisis of 2008, COVID-19 pandemic outbreak across the world etc. Examples of domestic market risk events are Ketan Parekh scam, NDA defeat in 2004 Lok Sabha elections, Demonetization etc. The impact of a market risk event on prices / returns depends on the severity of the event. For example, the impact of 2004 Lok Sabha election results and demonetization was limited, while the impact of the 2008 Global Financial Crisis was deep and lasted much longer. Market risk cannot be diversified; therefore, investors must be prepared for risk involved in equity investing.
Unsystematic Risk
Unsystematic risk affects a particular stock or sector. Unsystematic risk is specific to a company or an industry sector. Hence unsystematic risk is also known as specific risk. Examples of unsystematic are, a manufacturing company’s expansion running into rough weather due to legal / environmental factors, a drug exporters products being subjected to USFDA’s (Food and Drug Administration) regulatory action, entry of a new competitor in a particular sector affecting pricing power of existing players, a metal manufacturing company being affected by the commodity cycle, a bank’s net profit affected by bad loans etc. Unsystematic risk affects a specific company or a specific sector. However, Unsystematic Risk can be diversified by investing in a sufficiently large portfolio of stocks, across different industry sectors, so that impact of one stock / sector underperforming has only a limited affect on the portfolio performance.
Mutual funds and equity risks
Diversified equity mutual funds invest in a sufficiently large number of stocks across different industry sectors with the objective of diversifying unsystematic risk as much as possible. While market risk is unavoidable in equity investments, unsystematic risks can be reduced to a large extent by investing in diversified equity mutual funds. Some diversified equity mutual funds invest across different market capitalization segments e.g. large and midcap funds, multi-cap funds, flexi-cap funds etc. In such funds higher risks associated with more volatile market capitalization segments e.g. Midcaps, Small Caps are diversified.
Other risks
There are other risks linked to Unsystematic Risk that investors must be aware of, when investing in equity mutual funds.
Concentration Risk: Concentration risk refers to a substantial unfavourable impact on portfolio performance due to underperformance of one or a few of stocks. This risk arises if a fund has large exposures to a few stocks. You should see what percentage the top 5 / 10 stocks of a fund portfolio constitute the total portfolio value of the fund to get a sense of concentration risk.
Liquidity Risk: Liquidity risk refers to the difficulty of redeeming part or all the units of your mutual fund scheme. In extreme market conditions, the fund manager of your scheme may not find buyers for certain stocks, if you want to redeem for any reason. If there are stocks with low liquidity in your fund portfolio, you may have to face the following challenges:-
Sector risks: These risks affect particular industry sectors. The relative performance of different industry sectors depends on macro-economic environment and sector specific events. For example, defensive sectors like consumer staples, healthcare etc. tend to outperform bear market phases, while cyclical sectors like banking, automobile, cement and construction, capital goods etc. tend to outperform in bull phases. Sector specific events like regulatory actions, change in laws, changes in consumer preferences etc. can affect the performance of some industry sectors.
Since diversified equity mutual funds invest across industry sectors, sector specific risks are diversified. However, you should check how much Top 5 / 10 industry sectors constitute portfolio value in percentage terms to get a sense of sector risks. Sector risks are highest in sectoral funds. Investors need to distinguish between thematic and sectoral funds. A thematic fund with a fairly broad investment theme e.g. consumption can invest in multiple sectors and has limited exposure to any particular sector compared to a sectoral fund. Sector funds are suitable for investors with high risk appetites and understanding of sector risks.
Conclusion
Mutual funds are good investment options for retail investors because they provide risk diversification with relatively small investments. In this article, we discussed about risk in equity investment with regards to equity mutual funds. You should always understand the risks involved and make informed investment decisions. You should always consult with your financial advisor if required, so that you can invest in the right mutual fund scheme according to your risk appetite and investment needs.
Systematic Risk
Systematic risk, also known as market risk, affects the entire market, not just individual stocks or sectors. They are caused by events which affect the entire economy, domestic or global. Examples of major market risk events in the last 20 years or so are, 9/11 attack in New York City, Global Financial Crisis of 2008, COVID-19 pandemic outbreak across the world etc. Examples of domestic market risk events are Ketan Parekh scam, NDA defeat in 2004 Lok Sabha elections, Demonetization etc. The impact of a market risk event on prices / returns depends on the severity of the event. For example, the impact of 2004 Lok Sabha election results and demonetization was limited, while the impact of the 2008 Global Financial Crisis was deep and lasted much longer. Market risk cannot be diversified; therefore, investors must be prepared for risk involved in equity investing.
Unsystematic Risk
Unsystematic risk affects a particular stock or sector. Unsystematic risk is specific to a company or an industry sector. Hence unsystematic risk is also known as specific risk. Examples of unsystematic are, a manufacturing company’s expansion running into rough weather due to legal / environmental factors, a drug exporters products being subjected to USFDA’s (Food and Drug Administration) regulatory action, entry of a new competitor in a particular sector affecting pricing power of existing players, a metal manufacturing company being affected by the commodity cycle, a bank’s net profit affected by bad loans etc. Unsystematic risk affects a specific company or a specific sector. However, Unsystematic Risk can be diversified by investing in a sufficiently large portfolio of stocks, across different industry sectors, so that impact of one stock / sector underperforming has only a limited affect on the portfolio performance.
Mutual funds and equity risks
Diversified equity mutual funds invest in a sufficiently large number of stocks across different industry sectors with the objective of diversifying unsystematic risk as much as possible. While market risk is unavoidable in equity investments, unsystematic risks can be reduced to a large extent by investing in diversified equity mutual funds. Some diversified equity mutual funds invest across different market capitalization segments e.g. large and midcap funds, multi-cap funds, flexi-cap funds etc. In such funds higher risks associated with more volatile market capitalization segments e.g. Midcaps, Small Caps are diversified.
Other risks
There are other risks linked to Unsystematic Risk that investors must be aware of, when investing in equity mutual funds.
Concentration Risk: Concentration risk refers to a substantial unfavourable impact on portfolio performance due to underperformance of one or a few of stocks. This risk arises if a fund has large exposures to a few stocks. You should see what percentage the top 5 / 10 stocks of a fund portfolio constitute the total portfolio value of the fund to get a sense of concentration risk.
Liquidity Risk: Liquidity risk refers to the difficulty of redeeming part or all the units of your mutual fund scheme. In extreme market conditions, the fund manager of your scheme may not find buyers for certain stocks, if you want to redeem for any reason. If there are stocks with low liquidity in your fund portfolio, you may have to face the following challenges:-
- The fund house may not allow you to redeem or put restrictions on your redemption.
- The fund manager may have to incur a large loss by selling securities at very low prices to meet your redemption request.
- The fund manager may be forced to sell stocks, which he / she do not intend to sell to meet the redemption pressure. This will affect the returns of the investors who remain invested in the fund.
- Small cap stocks, which have lower free float market capitalization, are usually more illiquid than large and midcap stocks.
Sector risks: These risks affect particular industry sectors. The relative performance of different industry sectors depends on macro-economic environment and sector specific events. For example, defensive sectors like consumer staples, healthcare etc. tend to outperform bear market phases, while cyclical sectors like banking, automobile, cement and construction, capital goods etc. tend to outperform in bull phases. Sector specific events like regulatory actions, change in laws, changes in consumer preferences etc. can affect the performance of some industry sectors.
Since diversified equity mutual funds invest across industry sectors, sector specific risks are diversified. However, you should check how much Top 5 / 10 industry sectors constitute portfolio value in percentage terms to get a sense of sector risks. Sector risks are highest in sectoral funds. Investors need to distinguish between thematic and sectoral funds. A thematic fund with a fairly broad investment theme e.g. consumption can invest in multiple sectors and has limited exposure to any particular sector compared to a sectoral fund. Sector funds are suitable for investors with high risk appetites and understanding of sector risks.
Conclusion
Mutual funds are good investment options for retail investors because they provide risk diversification with relatively small investments. In this article, we discussed about risk in equity investment with regards to equity mutual funds. You should always understand the risks involved and make informed investment decisions. You should always consult with your financial advisor if required, so that you can invest in the right mutual fund scheme according to your risk appetite and investment needs.