How does market affects your Mutual Fund Investment?

‘Mutual fund investments are subject to market risks. Please read the offer document completely before investing.’ We are all familiar with the above-mentioned disclaimer which warns us about the inherent risks in a mutual fund portfolio. While mutual funds give attractive returns, one cannot ignore the risks involved therein. Mutual fund investments depend on the performance of the capital markets. Do you know how? The following diagram illustrates how –

Since the money you have invested in a mutual fund scheme is invested in the market, market movements affect the mutual fund investment. Let us understand this with a simple example –

10 investors invest Rs.100 each in a mutual fund scheme. This creates an investment pool of Rs.1000. If there are no charges deducted (as assumed), the mutual fund house now needs to invest Rs.1000 in various instruments. Suppose the following investments are done by the mutual fund house –

Now, if there are movements in the prices of shares of the invested companies, the portfolio would change. Here’s how –

Thus, despite a fall in the value of Company Z’s shares, the total portfolio gave a positive return because of the increase in the value of other company’s shares. This is how market movements affect mutual fund investments.

Now that you know that any change in the market affects mutual fund investments, you should also understand how the different types of mutual funds are affected by market movements. Let’s explore –

Equity mutual funds

Equity mutual funds are the most volatile. Since they invest primarily in equity shares and stocks of companies, any change in the market movement is reflected quite substantially on the returns of equity mutual funds. For instance, after the announcement of the Union Budget 2018, the equity market crashed considerably following the proposal to impose long term capital gains tax on long term equity gains. This crash brought down the Net Asset Value (NAV) of almost all equity mutual fund schemes which invested heavily in the equity market.

Debt mutual funds

Debt mutual funds invest primarily in debt instruments which have a fixed rate of interest. While 65% and more of the funds’ portfolio is invested in such debt instruments, 10% to 25% of the portfolio is also directed towards the equity market. This is done with a view to give good returns to investors. So, though the market movements do not affect the NAV prices of debt mutual funds very heavily, the component of equity investment in the portfolio is affected bring in a slight effect in the NAV of these funds. Moreover, based on the market movements, the interest rate of debt instruments might fluctuate. These fluctuations also cause changes in the NAV of debt funds because the fund managers redirect the funds’ assets to higher income generating instruments. Thus, market movements also have an indirect effect on debt mutual funds.

Liquid mutual funds

Liquid mutual funds are a type of debt mutual funds which invest in instruments with very short maturity tenure. These instruments also have a fixed rate of return thus eliminating stock price volatility. However, if the liquid fund’s portfolio has any equity exposure, market volatility would affect the fund’s performance, albeit very marginally. Other than this, liquid mutual funds are quite secured against market fluctuations.

The actual effect of market movements on mutual funds

We have seen how market movements affect mutual funds and the varied effects across the different types of mutual fund schemes. You must now be wondering – do adverse market conditions spell doom for your mutual fund investments?

The answer is – not actually. While it is true that market affects your mutual fund investments, you cannot ignore the diversification of investments which is done in mutual fund schemes. The total pooled investment is never invested in one single instrument. It is divided between various investments. Thus, if market fluctuations cause a downfall in the price of one or more investments, other investments might perform well. As a result, the actual effect is cushioned through diversification. Even in the earlier example where company Z’s share prices fell, the other two companies performed well giving a positive return. Thus, even if the share market crashes, the diversification of risks cushions the actual fall of mutual fund investments. As a result, the fall in the NAV of the fund is not very high and it is bearable.

So, if you are a mutual fund investor and worried about the market movements, especially after Union Budget 2018, relax. Though your mutual funds might post a negative growth in the short term, over the long term, they would give you positive and considerable returns.