Understanding Mutual Fund Risks, Part 2

In Part 1, we looked at five mutual fund risk categories—concentration, sector, price, business, and market—as well as how to evaluate those risks. Here we look at the other five major risk categories.

Credit risk: Mutual funds are hardly confined to stocks. Plenty of bond funds are available as well. For such funds, credit risk becomes an issue. Broadly speaking, bonds (and bond risk levels) can be divided into three categories: government, corporate, and junk. Anything below a BBB rating is generally considered a junk bond; BBB up to AAA are high-quality corporate paper. Look carefully at the specific bonds that make up a bond fund, just as you would with the stocks held by an equity fund. Funds that take on credit risk are susceptible to a systemic shock or just plain widespread fear that punishes corporate bond prices. (Following the highly-publicized failures of Enron and WorldCom, corporate bonds suffered from the perception that any company—no matter how stable it might seem—could be next. That fear proved unjustified, but its effects took a while to work their way out of the system.)

Interest rate risk: The other major risk for bond funds involves interest rates. Ironically—or perhaps just to demonstrate that life often isn’t fair—bonds with minimal credit risk are the ones most affected by interest rate risk. A U.S. Treasury bond is considered to have as close to zero credit risk as practically possible, but they pay such low rates that any significant rise in interest rates will wipe out their returns. Junk bonds, on the other hand, are already paying high rates because of their associated credit risk, so interest rates would have to rise truly dramatically to endanger their returns.

Liquidity risk: For liquidity risk to rear its ugly head, the situation at a mutual fund has to get pretty bad indeed—but “ugly” doesn’t do justice to just how vicious this potential downward spiral can become. To understand liquidity risk, remember that money flows into and out of mutual funds all the time. The liquidity of mutual fund investments is, in fact, one of their attractions. Since fund managers usually don’t keep large quantities of cash on hand—they are, after all, being paid to invest those funds more productively—larger redemptions can require the liquidation of some of a fund’s holdings. When you or I pull money out of a fund, we produce barely a blip, but if an institutional investor with millions of dollars decides to exit entirely, that has the potential to cause problems. If several large investors do so, problems are almost guaranteed. The issue is that the fund manager is faced with selling large blocks of securities to raise cash, and when large numbers of shares in a particular company get sold all at once, the price falls. Faced with further redemptions, the fund manager has to sell even more shares at a lower price, driving the stock down even more—and you get the idea of just how vicious this vicious cycle can become.

A liquidity crisis can also develop if the fund’s holdings suddenly become difficult to market—remember the days of collateralized debt obligations that no one could accurately value? The inability to sell at anything but bargain-basement prices can generate a downward spiral even more quickly. What makes this particularly cruel is that the lack of liquidity can result simply from investor perceptions, rather than a genuine problem with the investments in question. This makes liquidity risk difficult to spot—but fortunately such incidents are rare.

Emerging markets risk: The returns from emerging markets are sometimes grand because the risks are similarly oversized. When things are good, they can be very, very good. When things go bad…well, we’ve had the Asian financial crisis and the Russian financial crisis, and surely more will come. Check the exposure of any fund you’re considering to emerging markets, and be aware of how quickly geopolitical events, uncertainty, or even a natural disaster can send one or more of those markets into a tailspin.

Currency risk: The U.S. dollar and various foreign currencies are constantly fluctuating in relative value. If you invest in a fund with heavy overseas exposure, currency fluctuations can boost profits—or put a hole in them. The ways that currency risk can manifest are numerous, and some funds hedge against them while others do not. For any fund with exposure to foreign currencies, determine what (if any) hedging mechanisms are in place, and make sure you understand what will result from both a strengthening and a weakening U.S. dollar so that you can be prepared to react appropriately.

When investing in mutual funds, you should take the same steps you would with any other investment. Conduct your research so that you fully understand the nature of what you’re buying and what the potential risks to that investment are. Know your objectives clearly, and use your research to pick the fund or funds best suited to achieving them.