When you hear the term “risk in mutual funds,” the first thought is usually market volatility—the ups and downs in NAV due to stock market movements. But the reality is much deeper. Mutual funds carry multiple hidden risks that don’t grab headlines but can impact your wealth significantly over time.
These risks are like the submerged portion of an iceberg—often invisible until they cause real damage. In this blog, we’ll uncover the lesser-known risks associated with mutual fund decisions and provide practical strategies to manage them.
1. The Visible Risk: Market Volatility
Before diving into hidden risks, let’s acknowledge the obvious one.
- Equity funds fluctuate daily in response to market movements.
- Debt funds are sensitive to changes in interest rates.
- Hybrid funds balance both but are not immune.
Most investors expect this, but focusing only on volatility blinds us to subtler, long-term risks.
2. Concentration Risk: When Diversification Fails
A mutual fund may appear diversified, but underneath, it might be heavily tilted.
Signs of Concentration Risk
- Top 10 holdings make up more than 50% of the portfolio.
- Overweight allocation to a single sector like IT, BFSI, or Pharma.
- Heavy dependence on a single theme, such as ESG or infrastructure.
Real Example
During the 2008 financial crisis, funds with high exposure to banking stocks declined more than their diversified peers, disproportionately dragging down investors’ portfolios.
How to Manage It
- Review fund fact sheets for sector and stock allocation.
- Avoid having multiple funds with similar themes.
- Use portfolio overlap tools to ensure genuine diversification.
3. Liquidity Risk: The Silent Trap in Debt Funds
Most investors assume they can redeem mutual fund units at any time. While technically accurate, the underlying securities may not be liquid.
Where Liquidity Risk Appears
- Credit risk funds holding corporate bonds from lower-rated issuers.
- Small-cap equity funds with exposure to illiquid stocks.
- During market crises, many investors exit simultaneously.
Case Study: Franklin Templeton Crisis (2020)
Franklin Templeton had to wind up six debt schemes due to severe liquidity issues, locking up investor money for years.
How to Manage It
- Check the fund’s average maturity and credit quality.
- Avoid funds with too much exposure to AA or lower-rated bonds.
- Keep emergency funds in liquid or overnight accounts, not in risky debt funds.
4. Fund Manager Risk: The Human Factor
A mutual fund is only as good as the person managing it. A fund manager’s style, biases, or changes in leadership can impact long-term outcomes.
Hidden Manager-Related Risks
- Overconfidence Bias: Taking concentrated bets.
- Churn Risk: Excessive buying/selling leading to higher costs.
- Succession Risk: A proven manager leaves, and performance declines.
Example
Several investors exited funds when renowned managers, such as Prashant Jain (HDFC AMC), stepped down, fearing strategy changes.
How to Manage It
- Consider long-term performance, not just a 1–2 year period.
- Track consistency across market cycles.
- Avoid overreliance on a single fund manager’s reputation.
5. Expense Ratio Impact: The Compounding Killer
High costs don’t look dangerous in the short term, but over decades, they quietly eat into your returns.
Illustration
- Investment: ₹10 lakh for 20 years.
- Return before expenses: 12% CAGR.
- Fund A (Expense ratio 1.8%): Final corpus ≈ ₹70 lakh.
- Fund B (Expense ratio 0.8%): Final corpus ≈ ₹90 lakh.
👉 Just 1% difference in costs led to ₹20 lakh less wealth!
How to Manage It
- Prefer direct plans over regular plans.
- Compare expense ratios across similar categories.
- Ensure higher costs are justified by consistent alpha.
6. Regulatory & Policy Risk: The Government Factor
Policies and tax rules can change overnight, altering the attractiveness of funds.
Examples
- Debt fund taxation (2023): No more indexation benefits for LTCG.
- Dividend taxation (2020): DDT abolished, shifting tax burden to investors.
- Global funds (2022): SEBI temporarily restricted inflows due to foreign investment limits.
How to Manage It
- Stay updated on SEBI and CBDT announcements.
- Have flexibility in your portfolio to shift if rules change.
- Avoid chasing tax arbitrage alone—focus on fundamentals.
7. Currency & Global Exposure Risk
International funds add diversification but bring currency volatility.
- A falling rupee boosts returns from US-focused funds.
- A strengthening rupee reduces gains from global exposure.
Example
In 2022, the rupee depreciated sharply, boosting returns for US equity funds despite weak US markets.
How to Manage It
- Limit international allocation to 10–15%.
- Use global funds for diversification, not speculation.
8. Behavioural Risk: The Investor’s Own Enemy
Even if the fund performs well, investor behavior can still derail the results.
Common Behavioural Pitfalls
- Panic Selling: Exiting during crashes (March 2020).
- Return Chasing: Entering small-cap funds after they’ve already rallied.
- Over-diversification: Holding 10+ funds with overlapping exposure.
How to Manage It
- Follow a disciplined SIP strategy.
- Stick to your asset allocation plan.
- Review annually, not daily.
9. Hidden Risk in Goal Misalignment
Investors often pick funds without linking them to goals.
- Using small-cap funds for short-term goals = risky.
- Using debt funds for long-term wealth creation = suboptimal.
👉 The wrong fund for the wrong purpose creates invisible risk.
How to Fix It
- Map each fund to a financial goal.
- Use equity for long-term investments (10+ years), and debt for short-term investments (1–3 years).
- Use a hybrid for medium-term stability.
Why MFDs (Mutual Fund Distributors) Can Help Manage Risk in Mutual Funds
While DIY investing platforms are growing in popularity, they often lack personalized guidance and support. This is where MFDs add value.
How MFDs Reduce Hidden Risks
- Portfolio Guidance: They help you avoid over-diversification and sectoral overlaps.
- Behavioural Coaching: Prevent panic selling in crises and return chasing in bull runs.
- Goal Alignment: MFDs ensure you select funds that are suited to your time horizon and risk appetite.
- Regulation Updates: They keep you informed on taxation and SEBI changes.
- Fund Selection: Beyond star ratings, they evaluate fund manager style, expense ratios, and consistency.
DIY Platforms vs MFD Support
| Aspect | DIY Platform | Through MFD |
| Fund Selection | Based on filters and past returns | Holistic, goal-based selection |
| Behavioural Support | None | Guidance during market ups/downs |
| Tax/Regulatory Updates | Self-driven | Proactive advice |
| Long-term Discipline | Self-reliant | Handholding ensures consistency |
👉 An MFD is not just about “buying funds.” They act as a financial coach, helping you avoid costly mistakes that may be hidden beneath the surface.
Practical Risk-Management Checklist for Mutual Fund Investors
Managing the hidden risks of mutual fund investing requires a structured approach. Here’s a detailed checklist every investor should follow:
✅ 1. Diversify Across Categories and AMCs
Diversification isn’t just about holding multiple funds—it’s about having the right mix of funds.
- Across Categories:
- Large-cap for stability.
- Mid-cap/small-cap for growth potential.
- Debt or hybrid for safety and balance.
- International funds for geographic diversification.
- Large-cap for stability.
- Across AMCs (Asset Management Companies):
- Avoid putting all money in one AMC to reduce fund house-specific risks.
- Different AMCs follow different investment philosophies—diversifying reduces style risk.
- Avoid putting all money in one AMC to reduce fund house-specific risks.
👉 Rule of thumb: 5–6 well-chosen funds across categories and AMCs are often enough for most investors.
✅ 2. Review Fund Factsheets Every 6 Months
A factsheet is like a health report of your fund. Reviewing it prevents unpleasant surprises.
- Check Asset Allocation: Is the fund still following its stated mandate?
- Look for Portfolio Changes: Is there a sudden increase in sector or stock concentration?
- Track Fund Manager: Has there been a manager change in the last 6 months?
- Compare with Benchmark: Is the fund consistently beating its benchmark and peers?
- Expense Ratio Trend: Rising costs may erode returns silently.
👉 Action Tip: If your fund consistently underperforms its benchmark and peers for two to three years, consider switching to a more suitable option.
✅ 3. Don’t Chase the Latest Top-Performing Fund
Past performance is not a guarantee of future results.
- Many investors jump into last year’s top-performing small-cap fund, only to see underperformance later.
- Chasing returns increases the risk of buying high and selling low.
👉 Instead, look for:
- Consistency across 3, 5, and 10 years.
- Fund philosophy: Does it align with your risk tolerance and investment objectives?
- Risk-adjusted metrics: Sharpe ratio, standard deviation.
✅ 4. Maintain an Emergency Fund Outside Mutual Funds
Your investments should never be your only safety net.
- Keep 6–12 months of expenses in liquid instruments like savings accounts, FDs, or liquid funds.
- Emergency funds ensure you won’t be forced to redeem mutual funds during market crashes, locking in losses.
- It acts as a psychological cushion, preventing panic-driven redemptions.
👉 Remember: Mutual funds are for long-term wealth creation, not emergencies.
✅ 5. Consult a Financial Advisor or MFD for Personalized Allocation
While DIY platforms make transactions easy, they lack personalized guidance.
- A financial advisor or Mutual Fund Distributor (MFD) helps you:
- Create a goal-based portfolio (retirement, education, home, etc.).
- Select funds that align with your risk appetite and time horizon.
- Avoid behavioral pitfalls, such as panic-selling or over-diversification.
- Stay updated on regulatory/taxation changes.
- Create a goal-based portfolio (retirement, education, home, etc.).
- They provide the hand-holding that digital-only DIY platforms often lack.
👉 Think of an MFD as your investment coach, helping you stay disciplined for the long term.
✅ 6. Stick to Your Asset Allocation Plan
- Define how much of your portfolio is allocated to equity, debt, and hybrid investments based on your age and risk tolerance.
- Rebalance once a year—sell what has gone up and add to what’s lagging to maintain allocation.
- Example: If equity grows and becomes 75% of your portfolio (vs. the original 60%), shift some gains to debt.
👉 Asset allocation is the biggest driver of long-term returns and risk control.
✅ 7. Document and Review Your Goals Annually
- Write down your financial goals (short, medium, long-term).
- Map each mutual fund to a specific goal.
- Review annually to check if the timeline or fund selection needs adjustment.
👉 Goal alignment reduces the hidden risk of using the wrong fund for the wrong purpose.
Final Words: Awareness is the Best Risk Protection
The hidden side of mutual fund risks—liquidity, concentration, expenses, regulations, manager biases, and even your own behaviour—matters as much as market volatility. By proactively identifying and managing these risks, you not only safeguard your portfolio but also maximize long-term compounding power.
Investing in mutual funds is not about avoiding risk, but about understanding and managing it smartly.
Disclaimer
The information provided in this blog is for educational purposes only and should not be considered as financial, investment, or tax advice. Please consult a qualified financial advisor before making any investment decisions.
VSJ FinMart is an AMFI-registered mutual fund distributor (MFD) and does not provide investment advisory services. Mutual fund investments are subject to market risks; please read all scheme-related documents carefully before investing.