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For a retail investor, one of the best ways to manage risks is by investing in mutual funds. Photo: Shutterstock
Risk is an integral part of our lives. There is risk in even the most basic of our daily tasks, such as driving to work in the morning or taking up a new project at work. Similarly, when it comes to investments, risks are unavoidable. High risk assets usually offer high potential returns. On the other hand, if an investor tolerates modest risk taking, returns should also be expected to be low.
When an investor sets out to achieve his long-term goals, he must accept the fact that risks are a constant. Factors that determine risk appetite are the current scenario, past experience, future outlook and investment attitude.
Based on these responses, one can determine his/her risk appetite and be classified as a conservative, assertive or an aggressive investor. Once risk tolerance is established, an investor must attempt to enhance the value of his/her investment through prudent risk management. The key to investing wisely is not eliminating risk but garnering the ability to manage it. For a retail investor, one of the best ways to manage risks is by investing in mutual funds.
A mutual fund is not an investment in itself, but an investment vehicle that allows the investor to get a slice of various asset classes such as equity, debt and even real estate and gold. Mutual funds provide adequate diversification and an investor can easily use mutual funds to spread risks and keep his/her portfolio professionally managed. If one chooses the mutual funds carefully, they can serve as a good asset allocation tool that will help him/her balance the risks while maximising the returns.
Volatility is a word that is synonymous with the markets, be it equities, debt or any other asset class. One cannot invest in the markets and expect no volatility at all. Volatility measures the extent to which an asset’s return will deviate from the average performance. The main issue with volatility is that it is not correlated to the direction of an investment’s movement.
When an investor sets out to achieve his long-term goals, he must accept the fact that risks are a constant
A stock can be volatile because it suddenly jumps higher. Of course, investors are not worried by gains. For investors, risk is about the odds of losing money, and value at risk (VAR) is based on that common-sense fact. VAR answers the question, “What is my worst-case scenario?” or “How much could I lose in a really bad month?”
The VAR is a statistical technique used to measure and quantify the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. A VAR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage). To complement VAR analysis, which reflects potential changes in normal market conditions, one should consider stress testing. Stress testing identifies and analyses the impact of market conditions that could cause extraordinary losses. This type of testing should be designed to measure any potential major depreciation of the fund’s net asset value resulting from the unexpected changes in the relevant market parameters and correlation factors.
One can protect oneself against this systematic risk by investing regularly, putting in small amounts of money at periodic intervals, be it weekly, monthly or quarterly. Regular savings help an investor to stagger his/her investments, thus averaging out the impact of volatility faced should one have invested a lump sum amount. Macroeconomic or political conditions may impact markets anytime, making them volatile. By investing at periodic intervals, one can be assured that one is at least affected by such market cycles. In addition, the habit of making regular investments helps one to create wealth over the long term.
As an investor who has just been introduced to capital markets, it is easy to get carried away and overexpose oneself to a particular asset class. The lure of making quick gains when a particular stock/sector or asset class is performing well, may be hard to ignore. However, by doing that one puts all the eggs in one basket, thereby increasing one’s exposure to risk. To avoid a situation like this, one may revert to mutual funds. Diversification is an inherent feature of mutual funds which invest in carefully chosen stocks of varied sectors. Even when one is investing in sectorial or thematic funds if one is an aggressive investor, the stock picks are diversified even in the same sector. Therefore even if one finds oneself in a market that is falling, the impact on one’s portfolio will be limited as one’s risks would be well diversified.
Undertakings for Collective Investments in Transferable Securities (UCITS) is a term that applies to the majority of mutual funds in Europe that are offered to retail investors. According to the European Commission, they account for around 75 per cent of all collective investments in Europe. Investors in UCITS funds benefit from mandatory diversification of assets, assurance that the fund’s assets are held at an independent custodian bank, as well as easy to buy (subscribe) or sell (redeem) fund units, and the cost or proceeds correspond to the value of the investor’s share of the fund assets, subject to any fees and commission charges.
As clearly stated by the Committee of European Securities Regulators (CESR) in the risk management principles for UCITS, the risk management function in a UCITS company should operate in accordance with adequate standards of competence and efficiency. This function is hierarchically and functionally independent from the operating units and reports directly to the board of directors and senior management. The function should be appropriate and proportionate in view of the nature, scale and complexity of the company’s business and of the UCITS it manages. This segregation provides the retail investor with greater comfort that his/her investments are being managed with a target return within an adequate risk management framework.
It is worth remembering that investments and risks always go hand in hand, but if one uses mutual funds well as an investment route, one may protect oneself adequately from the many market risks. Risk management and proper asset allocation that is in sync with one’s financial plan, will help to minimise one’s losses and maximise one’s profits. Risk management is therefore considered an integral part of wealth creation over the long term.
Dorianne Tabone is risk manager at BOV Asset Management.
The value of the investment can go down as well as up. Investments should be based on the full details of the Prospectus, Offering Supplement and the Key Investor Information Document which may be obtained from BOV Asset Management Limited, Bank of Valletta p.l.c. branches/investment centres and other licensed financial intermediaries. BOV Asset Management Limited is licensed to provide investment services in Malta by the MFSA. The BOV Investment Funds is a common contractual fund licensed by the MFSA as a collective investment scheme pursuant to the Investment Services Act and the UCITS Directive.