The Risks of Investing in a Mutual Fund

Risk varies from one fund to another. You can measure risk by how often the fund's value changes and how big the changes tend to be. This is called volatility. The bigger and more often the changes in value, the more volatile the fund.

Every fund has a different degree of volatility, which depends largely on what the fund invests in. For example, if a fund invests only in interest-paying money market instruments offered by the Canadian government, there will be very little volatility. That's because the government guarantees to pay a certain interest rate and there's little chance it will fail to keep its promise. On the other hand, some funds invest heavily in technology stocks. Technology stocks can have frequent, large changes in value as their products go in and out of favour, so funds that invest mostly in technology stocks can be quite volatile.

When you're deciding which funds to invest in, you need to ask yourself how comfortable you'll be with volatility. Here are some important points that can help you decide:

- the length of time you're prepared to invest. The more time you have until you need to cash in your investments, the more you should be thinking about investing in funds that specialize in stock investments, also known as equities. These can be volatile in the short term, but over the long term, they've tended to provide higher returns than other kinds of investments.
- Your investment goals. Your goals are unique and will influence the amount of risk you'll want to think about taking. If you can reach your goal only by earning higher returns on your investments, you'll want to think about taking on more risk by making more volatile funds a larger part of your portfolio.

Your portfolio as a whole. A fund that may seem too risky on its own may be suitable as a small percentage of your portfolio. Why? Diversification. When you hold a variety of interest-paying and equity funds in your portfolio, you increase the potential for higher returns. At the same time, a good mix of investments tends to reduce wide swings in the value of your portfolio. That's because the various kinds of investments the funds hold tend to react differently to market and economic changes.

General investment risks

The volatility of a fund depends on the kinds of investments it makes. Here are some of the common risk factors that cause the value of funds to change. Not all risks apply to all funds.

Interest rate risk

The value of funds that invest in fixed-income securities can move up or down as interest rates change. Here’s why. Fixed-income securities — including bonds, mortgages, treasury bills and commercial paper — pay a rate of interest that’s fixed when they’re issued. Their value tends to move in the opposite direction to interest rate changes. For example, when interest rates rise, the value of an existing bond will fall because the interest rate on that bond is less than the market rate. The opposite is also true. These changes in turn affect the value of any fund investing in fixed-income securities.
In the case of money market funds, a fund’s yield is affected by short-term interest rates, and will vary.

Equity risk

Companies issue equities, or stocks, to help pay for their operations and finance future growth. Funds that buy equities become part owners in these companies. Changes in the value of the companies change the value of the fund. The price of a stock is influenced by the outlook for the company, market activity and by the larger economic picture, both at home and abroad. When the economy is expanding, the outlook for many companies will also be good, and the value of their stocks should rise. The opposite is also true.

Credit risk

Companies and governments that borrow money are rated by specialized rating agencies. High quality securities are those issued by organizations that have received high ratings. An example of a high rating is A-1 or better from Canadian Bond Rating Service. Some fund investments may not be rated or may have a credit rating below investment grade (BBB). These investments offer a better return than higher-grade instruments but have the potential for substantial loss as well as gain, as will the funds that buy them.

Foreign equity risk

When a fund invests in foreign equities its value is affected by stock market and general economic trends in the countries where the securities are issued. While the U. S. market has standards that are similar to those in Canada, other foreign markets may not. For example, some foreign markets may not be as well regulated as Canadian and U. S. markets. Their laws might make it difficult to protect investor rights. The political climate might be less stable. Business disclosure and accounting standards may be less stringent than in Canada and the U. S., making it difficult to obtain complete information about a potential investment. As a result, the value of foreign equities, and the value of funds that hold them, may rise or fall more rapidly and to a greater degree than Canadian and U. S. equity investments.

Currency risk

Funds that invest in foreign securities buy those securities with foreign currency. For example, funds use U. S. dollars to buy U. S. stocks or bonds. Because currencies change in value against each other, it’s possible that an unfavourable move in the exchange rate may reduce, or even eliminate, any increase in the value of that investment. The opposite can also be true — the fund can benefit from changes in exchange rates.

Liquidity risk

Some securities may be difficult to buy or sell because they’re not well known, or because political or economic events significantly affect them. These include investments in specific sectors, especially commodity sectors, and investments in developing or smaller markets. In addition, smaller companies may be hard to value because they’re developing new products or services for which there is not yet a developed market or revenue stream. They may only have a small number of shares in the market, which may make it difficult for a fund to buy or sell shares when it wants to. The value of funds that hold these investments may rise or fall substantially.

Derivative risk

There are risks in using derivatives:

- The hedging strategy may not be effective.
- There’s no guarantee that a market will exist when a fund wants to meet the terms of the derivative contract. This could prevent the fund from making a profit or limiting its losses.
- The other party to a derivative contract may not be able to meet its obligations.
- Stock exchanges may set daily trading limits on futures contracts. This could prevent a fund from closing a contract.
- The price of stock index options may be distorted if trading in some or all of the stocks that make up the index is interrupted. If the fund could not close out its position in these options because of interruptions or imposed restrictions, it may experience losses.
- The price of a derivative may not accurately reflect the value of the underlying security or index.

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