Identify Your Sources of Risk

Everywhere you look these days, investors are told to: do this, sell that, buy low, lookout for…, be careful of… But really, have taken the time to identify your sources of risk?  Today, my goal is to help you make sense of a mutual fund’s simplified prospectus.  I am thankful no one asked me to explain a complicated prospectus . Let’s start with the basics.

What is a mutual fund?

Basically it is a pool of investments which has been formed by the portfolio manager in order to meet the investment objective.  Perhaps the fund is designed to preserve capital, to generate income on a monthly basis, and/or to generate long-term capital growth.  When you invest in a mutual fund, you are buying a portion of that fund called a unit.  The more cash you put into the fund, the more units you own.

Investors share a mutual fund’s income, expenses, gains and losses in proportion to their holdings.  Mutual funds own different kinds of investments, depending on their objectives.  These include equities like stocks, fixed-income securities such as bonds and debentures along with cash or cash equivalents like treasury bills. The price of a unit changes everyday the markets are open, depending on how the investments are performing.

Risk and Return

As an investor, there is always a risk you could lose money.  Even guaranteed certificates of deposit have a risk of yielding less annual interest than the rate of inflation which results in a loss of purchasing power!  As a general rule, investments with the greatest risk have the greatest potential for gains (for losses too 8-().  Here is a list of many of the sources of risk to be aware of and a description to help make sense of them:

Capital Erosion Risk

If markets fell substantially and did not recover for a significant period (Sound familiar?!), a fund’s value would likely drop in line with the market decline.  This may result in less distributions in the future in order to return the net asset value closer to the initial unit price.

Credit Risk

This is the possibility that a borrower, or the counterparty to a derivatives contract is unable or unwilling to repay the loan or obligation.  Debt securities issued by companies or governments in emerging markets often have higher credit risk (Greek bonds anyone?).

Currency Risk

Most Canadian funds are valued in Canadian dollars.  However, global diversified funds that purchase foreign securities may be required to pay for such securities using a foreign currency and receive a foreign currency when they sell them.  Mike, The Financial Blogger, has a post about how to Use The Loonie’s Strength To Invest In the Eagle Market.

Interest Rate Risk

If a fund invests heavily in bonds and other fixed-income securities, the biggest influence on the fund’s value will be changes in the general level of interest rates.  If interest rates fall, the value of the fund’s units will rise.  Or as will be the case soon enough: if interest rates rise, the value of the fund’s units will tend to fall. Take a look at How Steady is Your Fixed Income? for an idea about where we are in 2010.

There are a plethora of other risks should you delve into more speculative funds, these include but are not limited to:

Issuer-Specific Risk

Liquidity Risk

Securities Lending, Repurchase and Reverse Repurchase Transaction Risks

Small Cap Risk

Specialization Risk

Trust Investment Risk

Remember, the most important thing you can do as an investor is to Take Responsibility For Your Investment Returns by identifying your sources of risk.  If you want to look at these or any other risks, let us know.  We’re here to help.

Author: Robert

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