Analysis of Risks in Fund Investments with Focus on Mutual Funds - Research Proposal Example

?Running Head: Analysis of Risks Analysis of Risks in Fund Investments with Focus on Mutual Funds Name Date of Submission Analysis of Risks in Fund Investments with Focus on Mutual Funds Introduction Recent developments in the financial markets have shown us that there are several risks in fund investments. Even government policies are being subjected to the ups and downs of the stock markets as far as the fund investment options are concerned. If the fund is engaged in activities which appear speculative or it has any other features which are inconsistent with the preferential risk weighting assigned to the fund’s assets, the holdings in that fund should be assigned to a high risk category (United States Office of the Federal Register, 2004). This approach becomes significant in the context of mutual funds, which can be considered instrumental in assessing the major risks like equity risk, currency risk, liquidity risk, etc. Emergence of hedged mutual funds and empirical research on the behaviour of fund managers has added new dimensions to the subject. Research Question What are the major risks of fund investments particularly in the context of mutual funds? Research Objectives 1. Obtaining a comprehensive understanding of the risks of fund investment using mutual funds as an instrument of in depth study. 2. Interrelation and comparison between mutual funds and hedge funds. 3. Assessment of the market risks in more details. The major market risks to be covered under this study are equity risk, commodity risk and currency risk. 4. Evaluation of the effects of liquidity risk on fund investments. Also, the study will evaluate certain risk factors that are not directly related to the markets. For example, employment risk and behavioural inconsistencies of fund managers will be analysed. 5. The new research area of hedged mutual funds will be explored. Literature Review Fund investments are subject to the financial dynamics of the markets (particularly the capital markets). There are various ways of fund investment. In today’s global environment almost all fund investment strategies, even those related to the pension funds, are increasingly involving the stock markets. Since mutual fund investments are the most popular options of fund investments, there is the need to analyse the risks entailed in it, although mutual funds are based on diversified portfolio and professional management systems that aim at mitigating the risks. With the lapse of time, risks entailed in the mutual funds are surfacing (although mutual funds have always been regarded as safer options of fund investment). Over the period of investment, there are significant alterations in the risk levels associated to mutual funds. Risk shifting might be caused by ill-motivated trades of unskilled or agency-prone fund managers who trade to increase their personal compensation. Alternatively, risk shifting might occur when skilled fund managers trade to take advantage of their stock selection and timing abilities (Huang, Sialm and Zhang, 2011). Stock selection directly relates to the analysis and effects of market risks, while timing abilities relate to liquidity risk. Timely liquidation issues concerning mutual funds are an important consideration. In this context, a relative analysis with respect to hedge funds becomes significant. Hedge funds have a more aggressively designed portfolio. “The standard measure of performance is the abnormal return defined by a hedge fund’s exposure to risk factors.” (Bollen and Whaley, 2009). Optimal changepoint regression can help risk exposures to shift and exhibit the impact on performance appraisal. In this regard, changing market conditions, or in other words, market risks are again considered to be very relevant (Bollen and Whaley, 2009). In detailing the market risks, the factor of rise and fall of the stock prices manifests as equity risk. Impact of contractual incentives on delivering higher risk-adjusted returns has been researched by Massa and Patgiri (2009). According to them, high incentive winner funds show relatively more active portfolio rebalancing. Theoretically, the risks must increase this way but that is not the actual case. In fact, the superior performance of the fund invested remains consistent (Massa and Patgiri, 2009). In the context of global exposure of the markets, mutual funds have become subject to currency risks as well since the currency specific value of an asset is becoming more critical. Foreign exchange rates need to be carefully evaluated while assessing the mutual fund risks. Moreover, today’s fund managers consider the commodity options too while designing the mutual fund portfolio. Volatility related to commodity prices is thus playing a more important role to evaluate the risks. (Bogle, 2010) Also, a different kind of risk is emerging. This risk is the employment risk. Employment risk entails the behavioural pattern of the manager when she or he embarks on a mutual fund portfolio. According to recent empirical results “fund managers with a poor midyear performance tend to decrease risk relative to leading managers to prevent potential job loss.” (Kempl and Ruenzi, 2009) However, of late, the emergence of mutual funds adopting the hedge fund strategies has been a key development in relation to the risks of fund investments. According to the findings of Agarwal, Boyson and Naik (2009), hedged mutual funds are outperforming the traditional mutual funds although they have less risk of financial hedging. This is definitely a new area of research extremely relevant to the study. Finally, it should be kept in mind that an investment in shares of a mutual fund is likely to be assigned to diverse risk categories according to the investment objectives that are stated in the mutual fund prospectus. (United States Office of the Federal Register, 2004) Methodology The research methodology will focus on a qualitative approach with ample review of related literature. Journal articles from SpringerLink, Elsevier, ScienceDirect, etc. are abundantly helpful. Analysis of empirical research based inferences with the help of recent financial literature is critical. Information obtained from reputed business magazines and newspapers can be used, and academic resources like text books can help to construct the theoretical backgrounds of the research. Collection of relevant data will involve interviews of the investors, managers and analysts, financial surveys and construction of analytic and interpretive framework. Suitable quantitative analyses will also be appended. Construction, application and analysis of the intended risk taking variables can be helpful. Regression approach can be adopted to analyse the trends. Inferential analysis of statistical data collected can be helpful for obtaining reliable results. Significance of the Study In the context of the risks in fund investments, mutual fund portfolios have traditionally been regarded as options that are relatively safe. However, in the recent past, risks entailed in mutual funds are becoming increasingly discernable. If these risks are focused on, we can obtain a clearer picture of the market scenario in relation to the other fund investment methods involving capital trading, pension funds, hedge funds, etc. By discovering the major risk factors of today, this study can help the investors to plan and implement better investment policies. Original contribution to knowledge will entail the analysis of most recent trends which will cover the topics like effects of employment risks and emergence of hedged mutual funds. Conclusion Risks of fund investments appear to be increasing since globalisation has created a more compact market environment and fund investment options like the mutual funds are subject to market risks. The viable way to evaluate the reliability of the fund as an investment option is to analyse the stated investment objectives of the fund set forth in its prospectus. However, this may not be sufficient always and intricate study of the risks of fund investments becomes an imperative. The proposed study will fulfil this requirement and derive useful results for the financial analysts, fund managers, and most importantly, investors. Reference List Agarwal, V., Boyson, N.M., and Naik, N.Y. (2009). ‘Hedge funds for retail investors? An examination of hedged mutual funds,’ Journal of Finance and Quantitative Analysis, Vol. 44, No. 2, pp. 273-305. Bogle, J.C. (2010). Common Sense On Mutual Funds (10th ed.). Hobokon: John Whiley & Sons Inc. Bollen, N.P.B. and Whaley, R.E. (2009). ‘Hedge fund risk dynamics: Implications for performance appraisal,’ The Journal of Finance, Vol. 64, No. 2, pp. 985-1035. Huang, J.C., Sialm, C. and Zhang, H. (2011), ‘Risk shifting and mutual fund performance,’ The Review of Financial Studies, Vol. 24, No. 5, pp. 103-145. Kempl, A., Ruenzi, S. and Thiele, T. (2009). ‘Employment risks, compensation incentives, and managerial risk taking: Evidence from mutual fund industry,’ Journal of Financial Economics, Vol. 92, No. 1, pp. 92-108. Massa, M. and Patgiri, R. (2009). ‘Incentives and mutual fund performance: Higher performance or just higher risk taking?’ The Review of Financial Studies, Vol. 22, No. 5, pp. 1777-1815. United States Office of the Federal Register (2004). L.S.A., List of C.F.R. Sections Affected. Washington D.C.: National Archives of the United States. Read More