How to Handle Negative Returns in Mutual Funds

Mutual fund investment enables investors to gain exposure to various asset classes through a professionally managed platform. This method enhances the dispersion of investment risk and allows for exposure to various sectors and instruments. Mutual funds are, nevertheless, subject to the fortunes of the overall financial markets, and hence, they can be volatile in value. These ups and downs can at times result in phases where the returns are not favorable to the investor, giving negative results for a period of time.

It’s important for investors to approach such scenarios with a practical mindset. Instead of reacting immediately to short-term losses, understanding the underlying reasons for the decline can provide clarity. The performance could be affected by factors like market trends, economic shifts, or fund-specific events. By analysing these factors and looking over their overall investment objectives, investors can ascertain whether change is warranted or whether it is better to remain on track.

Understanding the Different Categories of Mutual Funds 

Mutual funds are structured investment vehicles that pool money from multiple investors and allocate it across a portfolio of assets. The way a mutual fund is managed and the assets it holds define its category. Knowing the various types of mutual funds is important for investors who want to match their financial goals with their risk appetite.

Equity mutual funds: Equity mutual funds invest largely in shares of publicly listed companies. These funds are often segmented by the size of companies they focus on—such as large-cap, mid-cap, and small-cap funds—or by specific industries or sectors. Due to their exposure to the stock market, equity mutual funds can offer growth over time, but they also carry higher price fluctuations. When markets experience a dip, equity funds may reflect those changes through negative returns. Investors in such funds need to be comfortable with a certain level of volatility.

Debt mutual funds: Debt mutual funds, however, invest money in fixed income securities like government securities, corporate bonds, treasury bills, and other debt instruments. Such funds tend to be regarded as more stable than equities. Yet, they are subject to the movements in interest rates as well as credit quality of the issuers. When interest rates increase or when the debt owned by the fund suffers a downgrade, debt mutual funds can also register negative returns, although usually less drastically than equity funds.

Hybrid funds: Hybrid funds seek to strike a balance between growth and stability by investing in debt instruments as well as equity. The risk-reward profile of hybrid funds depends on the ratio of equity to debt. Greater equity exposure can translate to higher gains potential, but higher exposure to losses during market slides as well. Such funds are suitable for investors seeking a compromise between aggressive and conservative investment strategies.

Index funds: Index funds are passive investment funds that focus on mimicking the performance of a specific stock market index, such as Nifty 50 or Sensex. Their returns are directly tied to the index they follow. Therefore, when the market index drops, the fund’s returns typically decline as well, resulting in possible negative returns.

Sectoral and thematic funds: Sectoral and thematic funds channel investments into specific segments of the economy. These may include sectors such as banking, energy, healthcare, or technology. While such funds can perform well when their sector is thriving, they can also be more volatile and underperform if that sector is affected by negative trends or structural shifts.

International mutual funds: International mutual funds offer exposure to international equities and debt securities. International mutual funds assist investors in diversification beyond home markets. But they involve foreign currency exchange risk and international economic risks, which might cause variations or even losses in times of uncertainty overseas.

Knowledge of these categories of mutual funds allows investors to make decisions, basing their investment on their own risk tolerance and financial goals.

Additional Read: https://www.mstock.com/articles/mutual-funds 

How Mutual Fund Returns Work 

Understanding how mutual fund returns are calculated can help investors make informed decisions and assess the performance of their investments over time. These returns are not just dependent on market movements but are also shaped by how the fund is managed and its internal cost structure.

Net Asset Value (NAV): One of the key components of mutual fund returns is the Net Asset Value (NAV). This is the unit price of the mutual fund and is calculated by dividing the worth of the assets of the fund (after subtraction of liabilities) by the outstanding units. When the NAV increases over time, it reflects positive growth, while a drop indicates a decline in the value of the holdings, which may lead to mutual fund negative returns.

Dividends and interest: Another source of return comes from dividends and interest. If the mutual fund invests in dividend-paying stocks or fixed-income securities, the earnings from these instruments are distributed to investors or reinvested into the fund. These payouts contribute to the investor’s total return, although they do not directly affect the NAV.

Capital gains: Capital gains form an additional part of mutual fund returns. These are the profits earned by the fund manager from selling securities at a price higher than their purchase cost. The gains, when distributed, can add to the overall returns an investor receives, although realised gains may also be subject to taxation.

Expense ratio: Lastly, the expense ratio plays a critical role. This refers to the annual fee charged by the fund for its management and operational costs. A high expense ratio can reduce the investor’s effective return, especially in funds with moderate performance.

When evaluating fund performance, it’s important to consider total return, which includes NAV changes, dividends, capital gains, and the effect of fees. This holistic view helps determine whether the fund is meeting the investor’s expectations and financial goals.

Why Mutual Funds Sometimes Give Negative Returns

Several factors can lead to negative returns in mutual funds:

• Market volatility: Mutual fund returns are closely tied to overall market conditions. When markets experience sharp corrections due to economic slowdowns, global uncertainties, or geopolitical tensions, the underlying assets in a mutual fund may lose value. This can result in negative returns in mutual fund investments, especially in equity-based funds.
   
• Interest rate changes: Debt mutual funds are sensitive to interest rate movements. When interest rates rise, the value of existing bonds in the portfolio typically falls, leading to a drop in NAV. This inverse relationship can affect the overall return of debt funds during certain economic cycles.
   
• Credit risk: Debt mutual funds may hold bonds or instruments issued by companies or institutions. If any of these issuers face a credit rating downgrade or default on their obligations, the fund can incur losses. This type of risk directly affects the return potential of the fund.
   
• Sectoral declines: Some mutual funds focus on specific sectors like technology, energy, or healthcare. If the chosen sector goes through a difficult period due to policy changes, global trends, or sector-specific issues, funds invested heavily in that area may experience underperformance or losses.
   
• Currency fluctuations: International mutual funds invest in global assets. Their returns are impacted not only by the performance of those markets but also by exchange rate movements. A weakening foreign currency against the domestic currency can reduce the value of investments when converted, leading to negative returns from equity mutual funds in global portfolios.
  
   
• Management decisions: Fund managers play an active role in selecting investments. If they make untimely or poor allocation choices such as entering or exiting positions at the wrong time—it can impact the fund’s outcome. Even with a well-designed strategy, missteps in execution can lead to mutual fund negative returns.

Understanding these reasons can help investors better manage expectations and take a long-term view.

What You Can Do When Your Mutual Funds Show Losses 

Experiencing negative returns can be challenging, but there are strategies to manage such situations:

• Assess the situation: Start by analyzing the cause of the negative returns. Determine if the underperformance results from general market trends, economic factors, or stock selection and concentrated exposure problems within the fund. This can aid in determining if the situation is short-term or more structural in origin.
   
• Review investment goals: Go back to your initial investment intention. Query whether the fund is still consistent with your ability to bear risk, time horizon, and general goals. Occasionally, short-term setbacks will not justify altering your plan if the long-term plan is solid.
   
• Diversify: Spreading investments across different asset classes—such as equity, debt, and hybrid funds—or even within sectors and geographies, can reduce the impact of anyone underperforming an asset class. A diversified approach can smooth out returns over time.
   
• Avoid panic selling: Making hasty decisions during market dips may result in permanent losses. It’s often better to stay invested rather than exiting during low points, especially if the fund has a strong track record over the long term.
   
• Consult financial advisors: Seeking advice from professionals can provide clarity. They can offer insights based on your specific financial position and suggest adjustments or confirm that your current investments remain suitable despite short-term declines.
   
• Rebalance portfolio: Over time, your asset allocation can shift due to changes in market values. Rebalancing allows you to bring your portfolio back in line with your desired level of risk and ensure that your exposure is appropriate.
   
• Tax-loss harvesting: In some cases, selling mutual funds that have seen a loss may be used to offset capital gains in other investments. This can be a useful tool in managing tax liability, though it should be applied with a clear understanding of overall portfolio impact.

Taking thoughtful and informed steps helps in managing negative returns in mutual fund investments without disrupting long-term plans.

Conclusion

Negative returns on mutual funds are a natural risk in investment in market-linked products. With knowledge of the mutual fund types, how returns are actually generated, and the determinants that can cause losses, investors are capable of making informed choices. Adopting strategies like diversification, periodic review of portfolios, and consulting experts will enable management of turbulent times and balancing investments in line with long-term financial objectives.

Additional Read: What are Direct Mutual Funds? | m.Stock