The Risks of mutual funds

The major risk of investing in a mutual fund is the risk of loss of principal owing to a decline in NAV. Many types of risk exist: interestrate risk, market risk, and quality of the securities, to name a few. Rising market interest rates tend to depress both the stock and the bond markets, resulting in a decline in the NAVs of stock and bond funds. Adecline in market rates of interest results in an appreciation of stock and bond prices (and the NAVs of stock and bond funds). The quality of securities determines the volatility of the fund’s price swings. Stock funds that invest in small-company stocks and emerging growth stocks see greater upward swings in price during bull markets and greater downward swings during bear markets than conservative income equity funds, which invest in the stocks of larger, more established companies. Some small-cap funds have invested in small-cap stocks of dubious value, which has caused some losses to their funds.

With bank failures in the past and the shaky financial status of some savings and loan associations in the United States, investors are naturally concerned about the risk of insolvency of mutual funds. A mutual fund can always “go under,” but the chance of it happening is small. The key distinction between banks and mutual funds is the way in which mutual funds are set up, which reduces the risk of failure and loss owing to fraud.

Mutual funds typically are corporations owned by shareholders. Aseparate management company is contracted by shareholders to run the fund’s daily operations. Although a management company oversees the fund’s investments, the company does not have possession of the assets (investments). A custodian, such as a bank, holds the investments. Therefore, if a management company gets into financial trouble, it does not have access to the fund’s investments. Yet, even with these checks and balances, the possibility of fraud always exists. The SEC cleared two mutual funds whose prices were quoted in the financial newspapers along with all the other mutual funds, but they turned out to be bogus funds. A transfer agent maintains shareholders’ accounts and keeps track of shareholders’ purchases and redemptions. In addition, management companies carry fidelity bonds, a form of insurance to protect the investments of the fund against malfeasance or fraud perpetrated by its employees.

Along with these safeguards, two other factors differentiate mutual funds from corporations such as banks and savings and loan associations:
* Mutual funds must be able to redeem shares on demand, which means that a portion of its investment assets must be liquid.
* Mutual funds must be able to price their investments at the end of each day, which is known as marking to market. This adjustment of market values of investments at the end of the trading day reflects gains and losses.

For these reasons, mutual funds cannot hide their financial difficulties as easily as banks and savings and loans can. The SEC regulates mutual funds, but as noted earlier in this chapter, fraudulent operators can always find a way into any industry. Although the risk of fraud is always present, it is no greater in the mutual fund industry than in any other industry. Above all, you should be aware that you can lose money through purchasing a fund whose investments perform poorly on the markets.

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