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Types of General Investment Risk
The volatility of a fund depends on the kinds of investments it makes. Here are some of the common risk factors that cause the value of funds to fluctuate. Not all risks apply to all funds.
Interest rate risk
The value of funds that invest in fixed-income securities can move up or down as interest rates change. Here's why. Fixed-income securities –including bonds, mortgages, treasury bills and commercial paper – pay a rate of interest that's fixed when they're issued. Their value tends to move in the opposite direction to interest rate changes. For example, when interest rates rise, the value of an existing bond will fall because the interest rate on that bond is less than the market rate. The opposite is also true. These changes in turn affect the value of any fund investing in fixed-income securities.
In the case of money market funds, a fund's yield is affected by short-term interest rates, and will vary.
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Equity risk
Companies issue equities, or stocks, to help pay for their operations and finance future growth. Funds that buy equities become part owners in these companies.
Changes in the value of the companies change the value of the fund. The price of a stock is influenced by the outlook for the company, market activity and the larger economic picture, both at home and abroad. When the economy is expanding, the outlook for many companies will also be good and the value of their stocks should rise. The opposite is also true.
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Credit risk
Companies and governments that borrow money are rated by specialized rating agencies. High quality securities are those issued by organizations that have received high ratings. An example of a high rating is A-1 or better from Canadian Bond Rating Service. Some fund investments may not be rated or may have a credit rating below investment grade (BBB). These investments offer a better return and greater risk than higher-grade instruments – as will the funds that buy them.
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Foreign equity risk
When a fund invests in foreign equities, its value is affected by stock market and general economic trends in the countries where the securities are issued. While the U.S. market has standards that are similar to those in Canada, other foreign markets may not. For example, some foreign markets may not be as well regulated as Canadian and U.S. markets. Their laws might make it difficult to protect investor rights. The political climate might be less stable. Business disclosure and accounting standards may be less stringent than in Canada and the U.S., making it difficult to obtain complete information about a potential investment. As a result, the value of foreign equities, and the value of funds that hold them, may rise or fall more rapidly and to a greater degree than Canadian and U.S. equity investments.
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Currency risk
Funds that invest in foreign securities buy those securities with foreign currency. For example, funds use U.S. dollars to buy U.S. stocks or bonds. Because currencies change in value against each other, it's possible that an unfavourable move in the exchange rate may reduce, or even eliminate, any increase in the value of that investment. The opposite can also be true – the fund can benefit from changes in exchange rates.
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Liquidity risk
Some securities may be difficult to buy or sell because they're not well known, or because political or economic events significantly affect them. These include investments in specific sectors, especially commodity sectors, and investments in developing or smaller markets. In addition, smaller companies may be hard to value because they're developing new products or services for which there is not yet a developed market or revenue stream. They may have only a small number of shares in the market, which may make it difficult for a fund to buy or sell shares when it wants to. The value of funds that hold these investments may rise or fall substantially.
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Derivative risk
There are risks in using derivatives:
- The hedging strategy may not be effective
- There's no guarantee that a market will exist when a
fund wants to meet the terms of the derivative contract. This could prevent
the fund from making a profit or limiting its losses
- The other party to a derivative contract may not be
able to meet its obligations
- Stock exchanges may set daily trading limits on
futures contracts. This could prevent a fund from closing a contract
- The price of stock index options may be distorted if
trading in some or all of the stocks that make up the index is interrupted. If
the fund could not close out its position in these options because of
interruptions or imposed restrictions, it may experience losses
- The price of a derivative may not accurately reflect the value of the underlying security or index
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