Understanding systematic and unsystematic risks in large cap mutual funds

Posted On: 04 May 2024

Large cap mutual funds are pooled investment vehicles that primarily invest in the stocks of large, established companies with relatively stable earnings and higher market capitalisations. While these funds offer the potential for long-term growth and relative stability compared to smaller cap funds, they are not entirely immune to risks. Therefore, understanding the types of risks associated with is crucial for investors to make informed investment decisions.

This article explains systematic and unsystematic risks in large-cap mutual funds, elaborating on their characteristics and impact on investment performance.

Table of contents

Types of Systematic Risks in Large Cap Funds
Unsystematic Risks in Large Cap Mutual Funds
Difference between Systematic and Unsystematic Risks in Large Cap Mutual Funds
Systematic Risk vs. Unsystematic Risk – A Comparison Table
Advantages of Systematic Risk
Disadvantages of Systematic Risk
Types of Systematic Risks
How Are Systematic and Unsystematic Risks Measured?
Systematic and Unsystematic Risks – Impact on Different Asset Classes
Similarities Between Systematic Risk and Unsystematic Risk
How to Invest While Considering Systematic Risk vs. Unsystematic Risk?

Types of Systematic Risks in Large Cap Funds

Systematic risks, also known as market risks, are factors that affect the entire market and cannot be diversified away. In the context of large cap funds, systematic risks include:

Economic risk: Economic factors such as GDP growth, inflation, interest rates, and consumer sentiment can significantly influence the performance of large-cap stocks. Economic downturns or recessions may lead to decreased consumer spending, reduced corporate earnings, and lower stock prices, adversely affecting large cap funds.
Market risk: Market risk refers to the risk of losses due to factors affecting the overall stock market, such as geopolitical events, changes in investor sentiment, and fluctuations in global financial markets.
Interest rate risk: Changes in interest rates can impact the valuation of large-cap stocks, particularly those in interest rate-sensitive sectors such as banking and real estate. Rising interest rates may lead to higher borrowing costs for companies, potentially reducing profitability and stock prices, thereby affecting the large-cap mutual funds invested in these sectors.

Unsystematic Risks in Large Cap Mutual Funds

Unsystematic risks, also known as specific risks, are factors that affect individual companies or sectors but can be mitigated to an extent through diversification. In the context of large cap funds, unsystematic risks include:

Business risk: Business risk refers to the dangers that come from how a company operates, like dealing with competition, outdated technology, or bad management. If large cap funds invest a lot in companies facing these challenges, they could be affected by business risk.
Financial risk: Financial risk refers to the dangers associated with how a company manages its money, like borrowing too much, not having enough cash on hand, or facing bankruptcy. Companies with a lot of debt or shaky balance sheets might face financial risk, which could affect the value of their stocks held by large-cap mutual funds.
Sectoral risk: Sectoral risk comes from things that affect certain industries, like technology, healthcare, or energy. Large-cap mutual funds that focus on these industries could face sectoral risks from changes in how the industry works, new technology, government policy changes, or shifts in supply and demand.

Difference between Systematic and Unsystematic Risks in Large Cap Mutual Funds

Impact on returns: Systematic risks affect all investments in the market, while unsystematic risks only affect specific companies or industries, causing their stock prices to move independently from the rest of the market.
Diversification: Systematic risks cannot be diversified away as they affect the entire market. On the other hand, unsystematic risks can be mitigated through diversification by holding a diversified portfolio representing different industries, sectors and geographies.
Source of risk: Systematic risks arise from macro factors such as the state of the broader economy, rising interest rates, geopolitical tensions etc. which affect all companies. Unsystematic risks come from factors specific to a company or industry. The impact of this risk on a mutual fund depends on the nature of holdings and their concentration within specific sectors.

Systematic Risk vs. Unsystematic Risk – A Comparison Table

Aspect	Systematic Risk	unsystematic Risk
Definition	Risk inherent to the entire market or economy	Risk specific to a particular company or sector
Control	Control Cannot be controlled or mitigated entirely	Can be reduced through diversification
Examples	Inflation, interest rate changes, geopolitical events	Poor management decisions, labour strikes, product recalls
Impact	Affects all assets across the board	Affects specific assets

Advantages of Systematic Risk

While risk typically has a negative connotation in the context of investing, there are some ways in which systematic risk can provide some opportunities for investors and market analysts. These include:

Predictable patterns: Systematic risks often arise from macroeconomic factors, which are monitored closely and can often be forecasted to some extent, aiding in proactive planning.
Transparency: Market-wide risks such as inflation or interest rate changes are generally well-communicated, providing investors with time to adapt.
Insightful trends: Observing systematic risks helps investors gauge market sentiment and identify opportunities within broader trends.

Disadvantages of Systematic Risk

Here are some ways in which systematic risk can be more challenging for investors when compared to unsystematic risk

Unavoidable: Since systematic risk impacts the entire market, diversification does little to mitigate it.
Volatile returns: Factors like economic recessions can lead to sharp market declines.
Complex dependencies: Understanding and managing systematic risk require in-depth knowledge of global economic indicators.

Types of Systematic Risks

Market risk: The risk of losses due to overall market volatility.
Interest rate risk: Fluctuations in interest rates impacting bond and equity prices.
Inflation risk: The risk of purchasing power erosion due to rising prices.
Currency risk: Exchange rate fluctuations affecting investments in foreign assets.
Geopolitical risk: Political instability impacting global or regional markets.

How Are Systematic and Unsystematic Risks Measured?

Systematic risk: Measured using the beta coefficient, which indicates how an asset moves in relation to the overall market. A beta greater than 1 implies higher sensitivity, while a beta less than 1 indicates lower sensitivity.
Unsystematic risk: Measured using company-specific metrics, such as standard deviation of returns, financial ratios, and industry analysis.

Systematic and Unsystematic Risks – Impact on Different Asset Classes

Stocks: High exposure to both risks. However, diversification can mitigate the impact of unsystematic risk.
Bonds: Vulnerable to systematic risks like inflation and interest rate changes and unsystematic risk like credit risk – which is the risk of default by the bond issuer.
Real estate: Influenced by systematic risks like interest rate changes and local market conditions. There can also be unsystematic risks connected to a specific property or region.
Commodities: Affected by geopolitical risks and market dynamics.

Similarities Between Systematic Risk and Unsystematic Risk

Effect on returns: Both risks can affect the performance of investments.
Need for assessment: Proper measurement and assessment are vital for effective risk management.
Interrelation: Combined, they form the total risk associated with an asset.

How to Invest While Considering Systematic Risk vs. Unsystematic Risk?

Diversification: Mitigate unsystematic risk by holding a diverse portfolio across companies, sectors and industries.
Asset allocation: Balance investments across asset classes to mitigate the impact of specific risk types.
Stay informed: Monitor macroeconomic trends and company-specific developments regularly.
Long-term horizon: A longer investment horizon reduces the impact of short-term systematic fluctuations.

Conclusion

Large cap funds are associated with both systematic and unsystematic risks, which can significantly affect their performance. Systematic risks affect the whole market and can't be avoided, but unsystematic risks can be managed to a great degree through diversification strategies. Knowing about these risks can empower investors to make smart choices while selecting a suitable large cap fund for their investment portfolios.

FAQs:

What are some examples of unsystematic risks that can affect large cap funds?

Examples of unsystematic risks include company-specific events like management changes, product recalls, or lawsuits, as well as industry-specific factors such as shifts in consumer preferences or regulatory changes affecting specific sectors like healthcare or technology.

What strategies can investors use to mitigate risks in large cap fund investments?

Investors can potentially mitigate risks in large-cap mutual funds by diversifying their portfolios across different sectors and industries, thereby spreading risk. Furthermore, conducting thorough research on individual companies within the fund and regularly monitoring economic and market trends can help identify and manage potential risks effectively.

How can investors differentiate between systematic and unsystematic risks in large cap mutual funds?

Investors can differentiate between systematic and unsystematic risks in large cap funds by understanding the sources of each type of risk. Systematic risks stem from external factors affecting the entire market, while unsystematic risks arise from company-specific factors or sector specific factors.

What is the difference between systematic and unsystematic risk?

Systematic risk affects the entire market or economy and cannot be diversified away, while unsystematic risk is specific to a company or sector and can be reduced through diversification.

What is an example of a systematic risk?

An example of systematic risk is a global economic recession, which impacts all industries and markets broadly.

What is an example of unsystematic risk?

An example of unsystematic risk is a company's stock price decline due to poor management decisions or a product recall.

Why is it called systematic risk?

It is called systematic risk because it stems from overarching economic or market systems that affect all investments in a similar way.

Is currency risk systematic or unsystematic?

Currency risk is systematic, as it arises from macroeconomic factors like exchange rate fluctuations that impact global markets.

Is beta systematic or unsystematic risk?

Beta measures systematic risk, indicating an asset’s sensitivity to overall market movements.

What are the biggest systemic risks?

The biggest systemic risks include financial crises, geopolitical instability, widespread inflation, and major interest rate changes.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.