Be Aware of Management Risk to Your Mutual Fund

Management risk is something that you will need to be aware of when investing in mutual funds. This is a specific type of risk that is presented by having a mutual fund manager. Here are the basics of management risk and how it affects investors.

Management Risk

Management risk is a term that refers to the inherent risk of having someone else make investment decisions with your money. When you are giving your money to a mutual fund, a fund manager or team of managers is in charge of every investment decision for the portfolio. If the fund manager does not use sound judgment and proven techniques, this could negatively impact the investors. There are many different ways that a fund manager could hurt the investments of the shareholders.

Asset Allocation

One of the most common ways that fund managers make mistakes with a mutual fund is through asset allocation. Asset allocation involves what percentage of the money in a mutual fund is allocated to particular investments. For example, with a balanced fund, you will have some money invested in stocks, some invested in bonds and some in the money market. Depending on what the fund managers feel the market is going to do, they will allocate assets appropriately. If they think that the stock market is on the verge of a decline, they will liquidate most of their equities and put the money into bonds and the money market. If they think that the market is going up, they will increase their holdings in the stock market. However, if the fund manager does not read the market correctly, this could cost the fund a lot of money. If they purchase more stocks and the stock market plummets, this could lose significant sums of money for the investors.

Security Selection

Mutual fund managers are also in charge of selecting the particular securities that make up the mutual fund. They have to analyze all of the stocks and bonds available before they can make a purchase. They will use many different financial models and their own intuition when choosing securities. If the securities go up in value, everyone is happy. However, if the investments that they have chosen decline in value, the mutual fund will lose again. This means that a fund manager has to know which investments to choose and how much money to put into them.

Corruption

Management risk also involves the chance that fund managers are corrupt and act only according to what is best for them. It is possible that a fund manager will not care what happens to the mutual fund or to the fund's investors. When this is the case, the fund manager will make choices that are bad for investors, choices aimed at helping the manager first.

Example

Although it did not deal specifically with mutual funds, the Enron scandal is a classic example of management risk. The executives and the company made choices that helped only themselves and completely devastated the retirement funds of many of the lower employees.

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