Index Funds are passively managed <a href="https://www.mutualfundssahihai.com/en">Mutual Funds </a>that simply copy a popular market index like the Sensex or Nifty. While Index Funds carry relatively lower market risk as compared to actively managed funds, the <a href="https://www.mutualfundssahihai.com/en/are-fund-managers-necessary">fund manager</a> has limited ability to manage sharp corrections because the fund must hold all the securities in the index in the same proportion. He/she can’t buy more of an undervalued stock or sell an overvalued stock to take advantage of these market corrections.&nbsp;Since Index funds track specific market indices, they end up with a portfolio of established securities within a specific market segment be it large caps, small caps, multi caps, banking stocks, corporate bonds, etc. Thus, they limit the investor’s selection universe.&nbsp;In spite of mimicking a market index, these funds don’t provide the same return as the market index due to the presence of tracking error. &nbsp;A market index doesn’t incur any cost when it undergoes a change in composition i.e when some security is added or removed from it. An index fund has to bear transaction cost to ensure its portfolio mirrors that of the index. Also, there could be a time lag when the stocks or weightage of individual stocks in an index undergo some change. This lowers the Index Fund’s return as compared to its Index return.&nbsp;

Index Funds and risks associated with them

The riskometer attempts to give you a complete ‘risk’ picture for the <a href="https://www.mutualfundssahihai.com/en/what-are-various-types-mutual-funds">mutual fund scheme</a>. It does this by putting&nbsp;a risk score on every asset class held by the mutual fund scheme. Each debt or equity instrument and other assets, such as cash, gold, and other financial instruments found in mutual fund portfolios, is assigned a particular risk value.In the case of equities, each position in the portfolio is assigned a risk score based on three main factors:<ol><li>Market Capitalization: Small-cap stocks pose more risk than mid-cap stocks, which in turn are riskier than large-cap stocks. The risk value for each is updated every six months.</li><li>Volatility: Stocks with substantial daily price fluctuations are assigned a higher risk value. This is calculated from a stock's price behaviour over the past two years.</li><li>Impact Cost (Liquidity)1: Stocks with low trading volumes experience significant price shifts in large transactions. This raises the impact cost and corresponding risk value. This risk value is based on the three-month average impact cost, including the current month being evaluated.</li></ol>For debt securities, risk assessment involves the following factors:<ol><li>Credit Risk2: The risk value is lower for higher credit ratings (e.g., AAA/G-Sec/SDL/TREPS) and increases for securities with below-investment-grade ratings. This shift happens due to the rising likelihood of default in unrated and below-investment-grade securities.</li><li>Interest-Rate Risk: This risk is determined by using the Macaulay Duration of the portfolio. Bonds with longer maturity period have higher risk values due to their heightened sensitivity to fluctuations in interest rates.</li><li>Liquidity Risk3: Liquidity risk assessment considers factors like listing status, credit rating, and debt instrument structure.</li></ol>Additionally, <a href="https://www.mutualfundssahihai.com/en/who-regulates-mutual-funds-india">SEBI </a>has issued comprehensive guidelines for assigning risk values to other asset classes such as cash &amp; net current assets, derivatives, gold, foreign securities, REITs &amp; InvITs and more.The total risk score is calculated by averaging each asset's risk value in a <a href="https://www.mutualfundssahihai.com/en/how-do-you-build-your-mutual-fund-portfolio-scratch">mutual fund portfolio</a>.Lastly, this risk score is used to map the fund scheme to a certain risk level (i.e. Low, Moderately Low, Moderate, Moderately High, or High) on the riskometer .<table><thead><tr><th>Risk Label</th><th>Fund’s Average Risk Score</th></tr></thead><tbody><tr><td>Low</td><td>1</td></tr><tr><td>Low to Moderate</td><td>2</td></tr><tr><td>Moderate</td><td>3</td></tr><tr><td>Moderately High</td><td>4</td></tr><tr><td>High</td><td>5</td></tr><tr><td>Very High</td><td>6 or more</td></tr></tbody></table>It is important to note that the <a href="https://www.mutualfundssahihai.com/en/what-risk-o-meter-and-what-are-different-levels">riskometer </a>for each mutual fund scheme is evaluated monthly. Mutual Funds/AMCs will display the updated riskometer and portfolio information on their website and the AMFI website within ten days of each month's conclusion.1. Impact Cost relies on how much the stock price changes when a large purchase or sale occurs. 2. Credit risk indicates the likelihood of a borrower defaulting. 3. Liquidity risk is a bond's ability to be sold before maturity due to market demand.Disclaimer<a href="https://www.mutualfundssahihai.com/en">Mutual Fund investments</a> are subject to market risks, read all scheme related documents carefully.

How is the Riskometer for a scheme is derived?

Mutual Funds invest in securities and the nature of securities depends on the scheme’s objective.For instance, an equity or growth fund would invest in company shares. A <a href="https://www.mutualfundssahihai.com/en/What-are-liquid-funds">liquid fund</a> would invest in Certificates of Deposit and Commercial Paper.All of these securities are however traded in the ‘Market’. Company shares are bought and sold through the stock exchange, which is part of the Capital Market. Similarly, debt instruments like Government Securities, can be traded through a platform at the Stock Exchange or through specialised systems called NDS. These serve as markets to buy and sell securities and the buyers and sellers are diverse. So, the entire process of buying and selling, and price determination is done by the ‘market’.The price of any security is dependent on ‘market forces’, and the market acts on any news or development, making it difficult to predict the direction of the market, it's impossible to predict the price of a share or security in the short term. There are too many factors and players that influence its direction.Thus, every investor should know that there always exists a certain risk to security price from an all-important entity known as the ‘Market’. They should also know that <a href="https://www.mutualfundssahihai.com/en/what-is-a-mutual-fund">Mutual Funds</a> are designed to reduce this risk as much as possible.

Then why does the disclaimer say Mutual Funds are subject to market risk?

You’ve lent 5 lakhs to your friend who owns a start-up @8% interest (higher than current bank rate of 7%). Even though you’ve known him for years, you still run the risk that he may not return your money on time or may fail to pay back. Also, the bank rate may rise to 8.5% while you are stuck with 8%.Likewise, <a href="https://www.mutualfundssahihai.com/en/what-are-debt-funds">Debt Funds</a>&nbsp;invests your money in an interest-bearing securities like bonds and money market instruments. These securities promise to make regular interest payments to these funds. Hence Debt Funds are prone to three major risks like you when you lend money to friends.<ul><li>Firstly, since these funds invest in interest-bearing securities, their <a href="https://www.mutualfundssahihai.com/en/what-net-asset-value-nav">NAV</a> fluctuate with changing interest rates (interest rate risk). Prices of these funds fall when interest rates rise and vice-versa.</li><li>Secondly, these funds are subject to credit risk i.e. the risk of not receiving the regular payments from the underlying securities (e.g. bonds) they have invested in.</li><li>In the worst-case scenario, these funds can face default risk where the bond issuer fails to make the promised payment. When a bond in the underlying portfolio of a Debt Funds defaults in its payments, this impacts the interest income component of the fund thereby adversely affecting your total return from the fund.</li></ul>

Low Risk vs. High Risk Investments

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