Are There Any Mutual Funds Without Risk?

When you hear the phrase “low risk mutual funds”, it may be natural to imagine a nearly risk-free investment. However, it is important to recognise that no mutual fund is entirely without risk. Even the most conservative fund categories may involve exposure to interest rate changes, credit events or liquidity constraints.

What investors typically refer to as low-risk mutual funds are those with relatively lower volatility. The objective of this article is to explain how such funds operate, what potential advantages they may offer, the tax treatment involved, and the factors to judge while selecting them.

Table of contents

• Ways to identify low risk mutual funds
• Advantages of low risk mutual funds
• How do low risk mutual funds work?
• Taxability on low risk mutual funds

Ways to identify low risk mutual funds

Here are some criteria that may help investors identify relatively stable mutual fund schemes:

• Risk-o-meter: The clearest way to know a fund’s risk level is to check its Riskometer, which must be prominently displayed in all scheme-related communication as per regulatory norms. Some fund categories, such as overnight funds, arbitrage funds and liquid funds, may be classified low risk or low-to-moderate risk indicating that there may be relatively lower volatility on capital invested.
• Category choice: Broadly, debt funds typically tend to carry lower risk than equity funds. Within debt funds, those that invest primarily in short-term, ultra-short, liquid or low duration debt instruments tend to carry lower risk than long-duration counterparts.
• Duration of underlying instruments: A fund whose average Macaulay duration is low (e.g., 6 to 12 months) will usually have lower sensitivity to interest rate moves. Macaulay duration is the average time you must wait to get your money back from the bond's payments, considering the size and timing of each payment.
• Credit quality of holdings: The higher the credit rating of the bonds or money market instruments held, the lower the credit risk (though not zero).
• Liquidity profile of portfolio: Funds that hold very short-term instruments, money market instruments or high-quality debt securities may be able to convert their assets to cash comparatively easily, reducing liquidity risk.
• Historical volatility and drawdown track record: Checking how the fund’s NAV has behaved during market‐stress periods may give insight into the fund’s risk-adjusted return potential and volatility risk. (Past performance may or may not be sustained in future).

Using these criteria may help you identify mutual funds that may be suitable for a lower risk slot in the portfolio,but investors must remember that they are not entirely risk‐free.

Read Also: What are low duration mutual funds?

Advantages of low risk mutual funds

Here are some of the potential benefits that low risk mutual funds or moderate risk mutual funds may offer investors:

• Relatively lower volatility: Such funds tend to have smaller price movements compared to long duration or equity funds.
• Parking of surplus cash: Some low or low-to-moderate risk categories may be suitable for investors who want to temporarily park money in avenues where they may earn higher potential returns than savings accounts*.
• For short-term goals: Debt funds may offer somewhat higher yield potential than FDs* of a similar duration, while still offering relative stability.
• Diversification: Investors can choose lower duration debt funds to add relative stability to an equity-heavy portfolio for a better risk-return balance.
• Higher liquidity: Some shorter duration debt funds allow quick redemptions (though it varies from fund house to another), which could be beneficial for those needing easy access to funds.
• Professional management: Mutual funds offer access to a fund manager and in-house credit/interest rate research, which may reduce some operational risk. This may more convenient and less risky than independently looking for lower risk securities.

* Returns on fixed deposits/savings accounts are fixed, however, returns on mutual funds are subject to market risks

How do low risk mutual funds work?

To understand how these funds function, let’s break down some of the mechanics in simpler terms:

• Underlying instruments: Such funds mutual funds generally invest in very short-term treasury bills, government securities, high quality commercial paper, certificate of deposit, and short maturity corporate bonds.
• Interest rate risk management: Duration measures how sensitive a bond’s price is to changes in interest rates. Lower duration funds (for example, 6 months to 12 months) may have comparatively less NAV declines if interest rates go up.
• Credit/issuer risk management: Even short-term instruments may have credit risk (the issuer will not, or cannot, pay the interest or principal). Fund managers may limit holdings to high rating instruments to keep risks managed.
• Liquidity and redemptions: Since investors can redeem units at any time, there may have to be a buffer of very liquid holdings (cash, T-bills) to meet redemptions without having to sell illiquid bonds.
• Return drivers: Potential returns in these funds are primarily from interest income (coupons) with only modest capital gains/losses given the short maturities. The relative stability of a low risk debt mutual fund comes from the coupon return, not a large appreciation in NAV.
• Risk remains: Interest rates may rise, credit events may occur, or liquidity may tighten, all of which can impact potential returns even in conservative debt funds.

Thus, while these funds are structured to moderate risk, they cannot eliminate it altogether.

Taxability on low risk mutual funds

Tax treatment is a key part of understanding mutual funds, even those claimed to be “low risk”.

• For debt-oriented mutual funds (which invest 65% or more in debt/money market instruments) purchased on or after April 1, 2023, the capital gains are taxed at the investor’s applicable income tax slab rate, irrespective of holding period,
• IDCW Payouts paid out by debt funds are added to the investor’s income and taxed at slab rate; the former Dividend Distribution Tax (DDT) regime no longer applies.
• Some hybrid funds, such as equity savings funds or arbitrage funds, may fall under the low, low-to-moderate, or moderate risk categories. If these funds are taxed like equity-oriented funds (owing to the arbitrage component), the tax structure is as follows:

• Short-term capital gains tax of 20% applies to units held for less than a year
• Long-term capital gains of Rs. 1.25 lakh are tax-exempt. Thereon, the tax rate is 12.5%.

Note: Rates exclude cess, surcharge etc.

It is advised to check the scheme document and consult a tax adviser for personalised guidance.

Read Also: Conservative Mutual Funds: Are they a Low Risk Investment Option?

Conclusion

In summary, there are no risk-free mutual funds. There are mutual funds that intend to reduce risk relative to a high risk/high volatility category). These are typically debt funds with shorter maturities, higher credit quality assets and high liquidity. It could also include funds investing in arbitrage opportunities. It is important to evaluate your risk tolerance and goals and determine if the fund type is appropriate for your circumstances based on your goals and investment horizon. You should thoroughly read the fund's scheme documents and understand their risk parameters, as well as how they fit into their overall portfolio asset allocation.

FAQs

What criteria should investors consider when selecting a low risk mutual fund?

Investors should look at the fund category, average portfolio duration, credit rating mix, liquidity of holdings, expense ratio, historical NAV volatility, redemption terms, and the fund house’s governance practices. (Past performance may or may not be sustained in future).

What role does diversification play in reducing risk in these funds?

Diversification helps spread risks, both credit risk (no single issuer dominates) and maturity risk (holding bonds of varying maturities), thereby reducing the impact of any one adverse event on the overall portfolio.

How does professional fund management contribute to risk lowering in the context of these funds?

A skilled fund manager may manage the portfolio to maintain relatively lower volatility. This may include evaluating the credit quality of issuers, adjusting the portfolio as interest rate views change, maintaining liquidity buffers for redemptions, and handling reinvestment of short-term maturities efficiently, all of which can potentially contribute to moderating risk.

What liquidity aspects are highlighted for low risk mutual funds?

Important liquidity aspects include the ability of the fund to meet redemptions without forced sales, presence of cash or very short-term instruments in the portfolio, transparency of holdings, and the redemption terms (redemption time, exit load, etc). Good liquidity helps ensure you can access your money when needed, with less disruption to the fund.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.

The content herein has been prepared on the basis of publicly available information believed to be reliable. However, Bajaj Finserv Asset Management Ltd. does not guarantee the accuracy of such information, assure its completeness or warrant such information will not be changed. The tax information (if any) in this article is based on current laws and is subject to change. Please consult a tax professional or refer to the latest regulations for up-to-date information.