Impact of Inflation on Mutual Funds

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  • 04 Mar 2024
Impact of Inflation on Mutual Funds

It’s common knowledge that mutual funds are market-linked products, and several factors impact their performance. One critical factor that has an impact on mutual funds is inflation. Inflation, which refers to the gradual rise in the price of goods and services, often has a domino effect on mutual funds.

This is because when inflation is on the rise, companies in which your fund invests may experience a higher operating cost. This, in turn, can affect their profit margin, subsequently impacting returns on your investment.

Inflation Impact on Debt Funds

While inflation affects the performance of almost all types of funds, their impact on debt funds is quite profound. Debt funds are funds that invest in fixed-income securities such as treasury bills, corporate and government bonds, etc. They are generally less volatile than equities and offer predictable returns.

When inflation rises, the Reserve Bank of India (RBI) raises key policy interest rates to bring it down. When this happens, bond prices fall, and the value of your investment in debt funds tends to come down. Note that bond prices and interest rates share an inverse relationship. It means bond prices come down when interest rates increase and vice versa.

Let’s understand it with an example. Suppose you invest in a bond with a face value of Rs 1000 with an interest rate of 5%. It means you will receive an interest income of Rs 50 annually. If interest rates rise due to inflation, new bonds in the market are issued at a higher interest rate of 7%. As the new bonds offer a higher interest rate, the demand for existing bonds decreases. This, in turn, hurts your investments.

The longer the maturity of a debt fund, the greater the chances of it getting impacted by interest rate movements due to inflation. On the other hand, a decline in inflation brings down rates, which subsequently enhances returns from debt funds, particularly bond funds.

Impact of Inflation on Equity Funds

Inflation also impacts equity funds. High inflation brings down the real rate of returns. The real rate of returns is the returns you earn up and above inflation. For example, if the return from your equity mutual funds is 8% and inflation is 10%, the real rate of return is negative (-2%).

Also, inflation takes its toll on the profitability of companies and hits their revenues. This is because operating costs go up due to inflation, which brings down profits. With companies grappling with high expenses, the same brings down returns from funds investing in them.

Equity mutual funds can potentially deliver inflation-beating returns in the long run. In other words, if you stay committed to your investments in fundamentally strong equity funds, you can earn returns up and above inflation.

How to Combat the Impact of Inflation on Mutual Funds?

While you can do little to tame inflation, you can use specific strategies to ensure your mutual fund investments remain cushioned amid inflation. Some strategies you can adopt are:

Optimum Diversification

Optimally diversifying your portfolio across different types of funds can help you shock-proof your mutual fund portfolio. Ensure you have investments across equity, debt, and hybrid funds so that performance remains stable and doesn’t plunge amid high inflation.

Regularly Review and Make Adjustments

Monitor your portfolio and make the necessary adjustments. For instance, in a prolonged regime of high interest rates due to inflation, you can tone down your debt fund investments a little. On the other hand, when inflation is down, you can enhance your exposure to debt funds and increase your equity allocation.

Summing it Up

Whatever approach you take, make sure not to act under impulse. More often than not, impulsive decisions are likely to backfire and do more harm than good. In case of any doubt, consulting with a certified financial advisor is better. Remember, combating inflation is a part of mutual fund investment, and you can do so with the right approach and discipline.

FAQs on Impact of Inflation on Mutual Funds

In an inflationary environment, debt funds investing in fixed-income securities such as bonds can have a negative impact. This is because bond prices and interest rates move in opposite directions.

When markets are down due to an inflationary environment, investing in mutual funds via SIPs allows you to benefit from rupee cost averaging. You can accumulate more units during such times.

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