High Risk vs Low Risk Mutual Funds

What is High Risk in Mutual Funds?

High risk mutual funds have a greater chance of underperformance or capital loss, as they invest in asset classes or market segments. These segments are highly volatile, economically sensitive, or have uncertain long-term prospects.

Risk in this context can stem from:

• Market Volatility: Sharp price swings in underlying assets.

• Credit Risk: Potential default by issuers in debt-based funds.

• Sector Concentration: Heavy investment in industries prone to disruption or downturns.

• Leverage: Borrowing to amplify returns, which also magnifies losses.

High-risk mutual funds are those classified as “High” or “Very High” on SEBI’s Riskometer, which rates funds based on factors such as asset class, volatility, and portfolio concentration. These funds carry greater potential for fluctuations in value and are suitable for investors with a higher risk tolerance. Examples of high-risk mutual funds include:

• Equity Funds Focused on Small and Mid Caps: These funds invest in companies with significant growth potential but relatively limited financial stability. As a result, their prices can experience sharp fluctuations, particularly during market downturns.

• Sector Funds (Biotech, Technology, Energy): These funds concentrate investments within a single sector, making them highly vulnerable to industry-specific challenges. For instance, biotech funds face raised risks due to the high failure rates associated with drug approval processes.

• Thematic Funds (ESG, EV, AI): Thematic funds invest in emerging themes that may show strong promise; however, they often carry speculative elements and are susceptible to hype cycles that can lead to volatility.

• Funds with High Exposure to Emerging Markets: Such funds invest in markets where political instability, currency fluctuations, and limited regulatory oversight increase overall unpredictability and investment risk.

• Credit Risk Funds: These are a specific SEBI-defined debt category that must invest at least 65% of their portfolio in corporate bonds rated AA or below. They aim to deliver higher yields compared to safer debt funds, but carry a much higher probability of credit defaults and downgrades.

What is Low Risk in Mutual Funds?

Low risk mutual funds are designed to reduce the risk of capital loss. They primarily invest in stable, income-generating assets with outcomes that can provide predictable performance over time.

Characteristics include:

• Lower Volatility: Prices tend to fluctuate within a narrow range.

• Stable Income Streams: Investments in government securities, investment-grade bonds, or dividend-paying stocks.

• Capital Preservation: Focus on protecting invested principal, prioritising safety over growth with modest, consistent returns.

• Diversification: Broad exposure across assets to reduce concentration risk.

While returns are generally lower than high-risk funds, low-risk funds appeal to investors seeking stability, especially for short- to medium-term goals or during uncertain economic periods. Some of the common examples of low risk mutual funds are:

• Liquid Funds: Liquid funds invest in short-term money market instruments. They are suitable for investors seeking to deploy surplus liquidity for a short period while earning moderate returns. These are classified as Low risk on the Riskometer.

• Ultra-Short Duration Funds: Ultra-short duration funds primarily hold debt instruments with very short maturities. This structure helps reduce interest rate risk and provides relatively stable returns. Generally classified as Low to Moderate risk because of short maturity.

• Short Duration Funds: These primarily invest in government securities and high-quality corporate bonds with a portfolio maturity between 1–3 years. They offer relatively predictable income but still carry some interest rate risk. Most are classified as Low to Moderate risk on the Riskometer.

• Gilt Funds (Government Securities): These invest only in government securities, so credit risk is negligible. However, they are highly sensitive to interest rate movements. As a result, many gilt funds are classified as Moderate risk on the Riskometer, not Low risk.

Differences Between High Risk and Low Risk Mutual Funds

High-risk and low risk mutual funds differ in their return potential and volatility, asset composition, and suitability for different types of investors. To help investors make informed choices, the table below highlights the key distinctions.

Measures to Assess High Risk vs Low Risk Mutual Funds

When comparing high risk vs low risk mutual funds, investors should look beyond just return expectations. Risk can be assessed using two key approaches: 

• The SEBI Riskometer, and 

• Quantitative Risk Metrics

The Riskometer is easy for beginners to interpret, while the quantitative metrics provide more detailed insights for those who want to evaluate performance and risk more deeply. Together, these measures give investors a balanced way to assess mutual funds. 

1. SEBI’s Mutual Fund Riskometer

   The Riskometer is displayed on every mutual fund factsheet and classifies schemes into six risk levels. It gives investors a quick, visual understanding of how risky a fund may be.

   Risk Level	Fund Type & Characteristics
   Low	Overnight funds, Liquid funds, many Arbitrage funds (very short-term, minimal risk).
   Low to Moderate	Ultra-short duration, Money Market, and Low-duration debt funds (limited interest rate risk, stable returns).
   Moderate	Many Gilt funds, Banking & PSU debt funds, and Corporate Bond funds (low credit risk, moderate interest rate sensitivity).
   Moderately High	Gold ETFs, Index Funds, Diversified Equity Funds, and some Hybrid/Equity Savings funds (balanced or asset-linked risk).
   High	Large-cap or Flexi-cap equity funds, Focused equity funds, and some Gold ETFs (broad-based equity exposure, higher volatility).
   Very High	Small-cap and Mid-cap equity funds, Thematic/Sectoral funds, International equity FoFs (cyclical, concentrated, or currency-sensitive).

2. Quantitative Risk Metrics

   While the Riskometer offers a simple snapshot, investors can also use specific indicators to study how a scheme behaves in different market conditions.

   • Alpha (Excess Returns): Shows how much a fund has outperformed or underperformed its benchmark. A higher positive alpha signals superior fund management.

   • Beta (Market Sensitivity): Explains how much the fund’s returns move in relation to the market. Funds with a beta greater than 1 are more volatile, while those below 1 are relatively stable.

   • R-Squared (Benchmark Correlation): Measures how closely the fund’s performance mirrors its benchmark index on a scale of 0–100. Higher values mean the fund behaves more like its benchmark.

   • Standard Deviation (Volatility): Captures how much the fund’s returns fluctuate around their average. A high deviation reflects greater uncertainty, while a low deviation indicates steadier performance.

   • Sharpe Ratio (Risk-Adjusted Returns): Highlights how effectively a fund generates returns for each unit of risk taken. A higher Sharpe ratio is considered better.

   • Sortino Ratio (Downside Protection): Similar to the Sharpe ratio but focuses only on negative volatility, helping investors understand how well a fund guards against losses.

Parameters for Risk Assessment

The risk associated with an investment depends on an individual’s capacity to bear it. It can be evaluated using several key parameters:

1. Diversification:

   Diversifying investments is essential to reducing portfolio risk. While high dividend-paying stocks of established companies are generally considered safe and may offer moderate to high returns over time, they are still subject to market volatility, which can lead to sudden losses. Spreading investments across different instruments or sectors helps mitigate such risks. For example, an investor holding all their funds in a single high-return stock faces significant risk, whereas investing in multiple stocks across various sectors increases the likelihood that some will perform well.

2. Time Horizon:

   The duration for which investments are held can affect risk. Many investments may reduce risk over a longer tenure, while premature withdrawals can limit returns. For instance, a portfolio of low-risk Treasury bonds may seem safe, but if one bond loses value, it could significantly impact the portfolio. Holding a mix of investments with different risk levels for their full tenure helps minimise exposure to unexpected events.

3. Investment Expectations:

   Investors should maintain realistic expectations. High returns are generally accompanied by higher risk; understanding risk tolerance and the likelihood of underperformance is critical. Awareness of market volatility and its potential impact helps avoid unrealistic assumptions, ensuring returns are aligned with financial goals.

Risk Profiles During Recessions

During economic recessions, asset classes react differently to market stress and uncertainty. Knowing which mutual funds are resilient and vulnerable helps investors manage their portfolios more effectively.

Higher Risk Mutual Funds in Recessions:

• Consumer discretionary sector funds

• Small-cap equity funds (highly volatile, leveraged balance sheets)

• Industrial/manufacturing sector funds

• Credit Risk Funds (lower-rated debt, prone to downgrades)

• Commodity-based funds (oil, copper, etc.)

Lower Risk or Safest Mutual Funds in Recessions:

• Consumer staples-focused equity funds

• Utility sector funds

• Healthcare-focused equity funds

• Government bond funds (Gilt/short-duration debt)

• Gold exchange-traded funds (ETFs)

• Defensive, dividend-paying equity funds

Key Takeaways

Investors should choose between high-risk and low risk mutual funds based on their goals, time horizon, and risk tolerance. High-risk funds offer greater growth potential but come with volatility, while low-risk funds provide stability and capital protection with modest returns. A balanced portfolio that combines both can help investors manage risk effectively, preserve capital, and achieve long-term financial objectives. If you’re ready to implement these insights, you can start SIP in the best mutual funds in India today, along with consulting a financial advisor.