Investing in High-Risk Mutual Funds: A Bold Approach

August 22, 2024 Mutual Fund

In the dynamic world of investing, mutual funds have long been a preferred choice for those looking to grow their wealth over the long term. However, not all mutual funds are created equal. Some cater to the risk-averse, offering stability and steady returns, while others are designed for the daring investor willing to take on higher risk for the potential of greater rewards.

In 2024, with markets exhibiting increased volatility and uncertainty, investing in high-risk mutual funds is a strategy that appeals to those who are bold enough to embrace market fluctuations in the pursuit of significant returns.

High-risk mutual funds stand out for their potential to deliver substantial returns, albeit with a significant level of risk. These funds invest in securities that have a higher chance of fluctuating in value. High-risk mutual funds typically include equity funds, sector-specific funds, small-cap and mid-cap funds, and certain types of thematic funds. The volatility in these funds stems from their exposure to market dynamics, economic cycles, and specific sector performances.

[Read: Navigating the 2024 Market Volatility: Key Investment Strategies for Your MF Portfolio]

As we steer through 2024, understanding the intricacies of high-risk mutual funds becomes crucial for investors looking to optimise their portfolios in a volatile market environment. While the potential for high returns is a key attraction, the risk factor is equally significant.

This article explores various categories of high-risk mutual funds, delves into their performance and characteristics, and discusses their suitability for different types of investors in the current market landscape.

Categories of High-risk Mutual Funds

Let’s delve into the various categories of mutual funds that are generally considered high-risk.

1. Mid and Small Cap Equity Mutual Funds

Mid and small-cap funds are equity mutual funds that focus on investing in companies with medium to small market capitalisations. These funds are considered high-risk due to the inherent volatility of mid and small-cap stocks, which are more susceptible to market fluctuations, economic changes, and company-specific risks.

However, they also offer significant growth potential, especially during periods of economic expansion or market rallies. In 2024, mid and small-cap funds have drawn considerable attention from investors looking to capitalise on their growth prospects despite the increased market volatility.

Data as of August 21, 2024
Do note past performance is not an indicator of future returns
The securities quoted are for illustration only and are not recommendatory.
(Source: ACE MF, data collated by PersonalFN Research) 

The second half of 2024 brought challenges as global economic uncertainties and inflationary pressures led to increased market volatility. Mid and small-cap funds were particularly affected, with many experiencing significant drawdowns. Nevertheless, despite these fluctuations, the long-term performance of these funds remains promising, especially for investors with a higher risk tolerance who can weather short-term volatility for potential long-term gains.

Mid and small cap funds in India are encountering stretched valuations when compared to their large-cap counterparts. This divergence has emerged as a result of the rapid appreciation in stock prices within the mid and small cap segments, driven by strong investor interest and optimism about the growth prospects of smaller companies.

However, this surge in valuations has raised concerns about sustainability, as these stocks are now trading at higher price-to-earnings (P/E) ratios relative to their historical averages and large caps.

Data as of August 21, 2024
Do note past performance is not an indicator of future returns
The securities quoted are for illustration only and are not recommendatory.
(Source: ACE MF, data collated by PersonalFN Research)

As you can see from the above table, the average P/E ratio for large-cap funds is between 21- 25. This relatively moderate valuation reflects the stability and maturity of large-cap companies, which tend to have more predictable earnings and less volatility.

However, the average P/E ratio for mid-cap funds has stretched to around 30-32. This higher valuation is driven by strong investor demand and expectations of robust growth, but it also raises concerns about potential overvaluation, especially if growth slows or market sentiment shifts.

Small-cap funds are trading at an even higher P/E ratio, typically ranging from 32-36. This steep valuation underscores the significant optimism surrounding the growth potential of smaller companies. However, it also amplifies the risks, as small caps are more susceptible to market volatility and economic downturns.

These stretched valuations in mid and small cap funds suggest that investors are pricing in aggressive growth expectations, which may not be sustainable if market conditions deteriorate. In contrast, large-cap funds, with their more moderate P/E ratios, offer relatively better value and stability in the current market environment. This calls for cautious investment strategies, especially for those considering exposure to the more volatile mid and small cap sectors.

Suitability: Mid and small-cap funds are best suited for investors with a high-risk appetite and a long-term investment horizon. These funds are ideal for those who can withstand the inherent volatility of the mid and small-cap segment and are willing to stay invested through market cycles. Younger investors, or those with a diversified portfolio that can absorb potential losses, may find these funds particularly appealing.

[Read: Highest Return Mutual Funds in the Last 10 Years – Small Cap Fund Category]

For a balanced investment strategy, mid and small-cap funds should typically form a part of an investor’s overall portfolio rather than being the sole focus. Allocating a portion of the portfolio to these funds can enhance diversification and increase the potential for higher returns, especially in a bullish market. However, due to their volatility, it’s crucial that investors complement these funds with more stable, low-risk investments, such as large-cap or multi-cap funds, to balance the overall risk.

2. Sector-oriented Mutual Funds

Sector-specific mutual funds, a subcategory of equity mutual funds, have gained popularity for their targeted investment strategies, focusing on specific sectors. These funds are inherently high-risk due to their concentrated investments in particular market segments, making them highly sensitive to sectoral trends and economic shifts.

Unlike diversified equity funds, these funds channel investments into particular industries or themes, making them more vulnerable to sector-specific risks. In 2024, the performance of these funds has been a mixed bag, with some sectors experiencing robust growth while others have faced significant challenges due to market volatility and global economic uncertainties.

Table: Top Performing Mutual Fund Sectors in 2024

Data as of August 21, 2024
Do note past performance is not an indicator of future returns
The securities quoted are for illustration only and are not recommendatory.
(Source: ACE MF, data collated by PersonalFN Research) 

The risk ratios provide a comparative view of risk-adjusted returns for different mutual fund categories:

Pharma Funds have a Standard Deviation (SD) of 14.50, indicating relatively high volatility. Their Sharpe ratio of 0.39 and Sortino ratio of 0.87 suggest moderate risk-adjusted returns, with a better performance in terms of downside risk compared to the benchmark.

[Read: Best Pharma Mutual Funds: SBI Healthcare Opp Fund vs. ICICI Pru Pharma Healthcare & Diagnostics Fund]

FMCG Funds show a lower SD of 12.80, implying less volatility. Their Sharpe ratio of 0.45 and Sortino ratio of 1.00 reflect superior risk-adjusted returns and effective downside risk management.

Infrastructure Funds have a higher SD of 16.69, signifying greater volatility. With a Sharpe ratio of 0.42 and a Sortino ratio of 0.90, these funds provide good risk-adjusted returns, though they experience higher fluctuations than FMCG Funds.

Thus, FMCG Funds offer the best balance of risk and return, with lower volatility and higher risk-adjusted ratios. Infrastructure and Pharma Funds have higher volatility but also provide strong returns relative to their risk profiles.

Over the past year, certain sectoral funds, particularly those focused on technology and healthcare, have delivered robust returns. The technology sector has benefited from continued digital transformation and advancements in artificial intelligence, while healthcare has remained strong due to the ongoing global demand for innovative medical solutions.

However, sectoral funds also experienced significant volatility, with sharp corrections during periods of market sell-offs, reflecting the inherent risk associated with concentrated investments.

Suitability: These funds are best suited for investors who have a strong understanding of the specific sector and are willing to take on concentrated risk. They are ideal for those looking to capitalise on specific economic trends or innovations.

[Read: Power Your Portfolio: 5 Sector & Thematic Funds]

3. Thematic Mutual Funds

Thematic funds invest in a particular theme, such as ESG (Environmental, Social, and Governance), global megatrends, or emerging markets. These funds are similar to sector funds but focus on broader themes that may span multiple industries.

Thematic funds have varied performances based on the theme. Funds centred around infrastructure and green energy have performed well, driven by government initiatives under the Modi 3.0 administration. The emphasis on infrastructure development, particularly with the push for modernising transportation networks and boosting urban development, has bolstered infrastructure funds.

[Read: Thematic Funds Become Market Leaders with Record-High AUM Growth]

Similarly, the government’s focus on renewable energy and sustainability has provided a strong tailwind for green energy funds. However, these sectors are also sensitive to changes in government policy and economic conditions, making thematic funds a high-risk, high-reward proposition.

Suitability: Thematic funds are suitable for investors with a specific interest in the theme and a higher risk appetite. They are ideal for those looking to align their investments with personal values or capitalise on global trends. However, given their concentrated exposure, these funds should ideally complement a well-diversified portfolio rather than serve as the core holding.

4. Momentum Mutual Funds

Momentum mutual funds, a subcategory under equity mutual funds, are designed to capitalise on market trends by investing in stocks that have shown strong performance over recent periods. These funds operate on the principle that stocks which have outperformed in the recent past are likely to continue their upward trajectory in the near future.

Nevertheless, this strategy inherently carries a high level of risk, as it relies on the continuation of market trends, which can be unpredictable and subject to sudden reversals.

Momentum mutual funds in India have delivered mixed performance, reflecting the volatility and fluctuations of the Indian equity market in 2024. The year began on a strong note, with these funds benefiting from the bullish trends in sectors such as technology, pharmaceuticals, and financial services. Stocks in these sectors gained momentum as they were buoyed by strong earnings reports and positive market sentiment.

[Read: Why Are Markets Turning Volatile and Risks to Watch Out For]

However, as the year progressed, the market faced increased volatility due to inflationary pressures, global economic uncertainties, and geopolitical tensions, which impacted the performance of momentum funds.

Momentum mutual funds are designed to capitalise on trends in the market by tracking the performance of a momentum index. These funds follow a passive investing strategy, which means they aim to replicate the returns of an index that identifies stocks or assets with strong recent performance and positive momentum.

Data as of August 21, 2024
Do note past performance is not an indicator of future returns
The securities quoted are for illustration only and are not recommendatory.
(Source: ACE MF, data collated by PersonalFN Research) 

The Nifty200 Momentum 30 Index is a specialized benchmark designed to capture the performance of the top 30 companies from the Nifty 200 index that exhibit high momentum. This index selects stocks based on their past performance, specifically those that have shown significant price momentum over a defined period. By concentrating on high-momentum stocks, this index aims to deliver superior returns, though it may also experience higher volatility compared to broader market indices.

The Modi 3.0 government’s policies have also played a significant role in shaping the performance of momentum mutual funds. The market’s reaction to policy announcements, particularly around taxation and regulatory changes, introduced volatility, leading to sharp corrections in certain sectors. For instance, sectors like manufacturing and traditional energy, which faced headwinds due to policy shifts, impacted the performance of momentum funds with significant exposure to these areas.

Suitability: In the context of 2024, with the Indian equity market exhibiting significant fluctuations, momentum mutual funds offer a bold investment option for those who are willing to actively monitor market trends and adjust their portfolios accordingly. Investors who understand the dynamics of momentum investing and have the ability to ride out short-term volatility may find these funds rewarding. However, it is crucial to approach these investments with caution, as the performance of momentum funds can be heavily influenced by market sentiment and external economic factors.

5. International/Global Mutual funds

International or global funds invest in companies outside of the investor’s home country. These funds offer diversification benefits but also come with risks related to currency exchange rates, political instability, and economic cycles in different countries.

Over the past year, the performance of these funds has been influenced by a mix of factors, including geopolitical tensions, varying economic recovery rates across regions, and fluctuating exchange rates. While some global funds have benefited from strong performances in emerging markets and robust growth in technology and healthcare sectors, others have struggled due to economic slowdowns and political uncertainties in key regions.

[Read: Is It Worthwhile Adding International Mutual Funds to an Investment Portfolio?]

The past few years have been particularly challenging for international mutual funds due to heightened geopolitical risks and trade tensions between major economies. For instance, recent tensions between the U.S. and China have impacted global supply chains and trade flows, creating volatility in markets heavily reliant on international trade. In Europe, the ramifications of the Russia-Ukraine and Israel-Hamas wars loom large, with maritime transport disruptions through the Red Sea posing challenges to global supply chains and inflationary pressures.

Additionally, fluctuations in currency exchange rates have also played a crucial role, as the strength of the U.S. dollar and other major currencies has affected the performance of international investments.

Suitability: International funds are suitable for investors looking to diversify their portfolios geographically and are willing to take on additional risks related to foreign markets. They are ideal for those who want exposure to global growth opportunities. However, due to the complexity of global markets, investors should be well-informed and prepared for the additional risks associated with international investments.

To conclude…

In the current market environment of 2024, characterised by economic uncertainties and geopolitical tensions, the risk-reward balance of high-risk mutual funds is more pronounced than ever. Investors must approach these funds with a well-thought-out strategy like the core & satellite style, keeping a long-term perspective and staying informed about market conditions.

While high-risk mutual funds can be a valuable component of a diversified investment portfolio, they are best suited for those who are prepared to navigate their inherent volatility and seek significant growth opportunities.

This article first appeared on PersonalFN here