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Understanding Mutual Fund Risks, Part 1

Sometimes investors tend to think of mutual funds as an investment panacea, since funds typically invest in a wide range of securities and thus provide automatic diversification. The tremendous amount of money invested in mutual funds also tends to reassure investors. According to the Investment Company Institute, total mutual fund investments reported to the Federal Reserve amounted to $2.564 trillion as of May 23, 2012.

However, as with any investment vehicle, risks still exist. As an educated investor, you should understand those risks before undertaking any investment in mutual funds. Here we will look at five of the ten major risk categories, with the remaining five to be covered in Part 2.

Concentration risk: It stands to reason that if diversification is an important advantage of mutual funds, anything that creates a heightened exposure to a single company is risky. Check the top holdings of any fund that you’re considering—the information is readily available in the prospectus. If the fund has more than 10% of its holdings in a single company or multiple companies with exposures above 5%, it is courting danger. Consider what happened to certain high-profile financial sector stocks during the 2008 financial crisis and its aftermath. A substantial stake in a large and seemingly solid company (or three or four) can unexpectedly go bad, with predictable effects on the fund’s net asset value (NAV).

Sector risk: Sector risk is just concentration risk writ large—excessive weighting of a sector rather than a company. Other than financials in 2008, you may recall the entire technology sector taking a bath when the Nasdaq bubble burst in 2000. Examining a fund for sector risk works just like looking for concentration risk, except that you may have to research individual stock holdings if you’re not certain of the sector to which each company belongs. Of course, some funds are specifically designed to specialize in a given sector. In that case, you can ignore sector risk since you’re already choosing to concentrate an investment using a mutual fund.

Price risk: The higher a stock’s price-to-earnings (P/E) ratio, the more it is likely to suffer from bad news of any kind. If a fund has a high concentration of such stocks, it will take a bigger hit as a result. Determining price risk is a matter of determining whether the fund uses a value-based or a growth-based approach to stock selection. Since value investing by definition looks for P/E values that are below fair value, funds that emphasize growth stocks are much more subject to price risk. Remember that a company’s performance can still be quite respectable yet not justify the stratospheric P/E ratios sometimes associated with a growth stock, which means it can be punished for the slightest reason.

Business risk: All stock investing carries with it some degree of business risk—the possibility that a company will decline or fail because of changing business, economic, or industry conditions. It could be poor management, failure to prepare for the future, or a systemic issue such as the widespread exposure to questionable collateralized debt obligations that caused so much panic in 2008. Avoiding business risk is trickier and requires the same sort of research that applies to picking individual stocks, except of course for the minor detail that a typical mutual fund may invest in dozens or scores of individual stocks. With business risk, your best protection is generally ensuring adequate diversification of any fund you select while watching for industry-wide risk in sector-specific funds.

Market risk: Markets go up and down; that’s just the nature of things. Sometimes you can do everything right and still lose money. The only real defense against market risk is a general preparedness for downturns, primarily through diversification since rarely does every single asset class suffer at the same time.

Mutual funds are an excellent tool for pursuing investment opportunities in specific sectors, geographic regions, asset classes, and so forth. They are also substantially less risky than individual stocks. However, risks do exist, and you should enter any investment with eyes wide open. We’ll address five more specific mutual fund risks in Part 2.


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