Are mutual funds safe? Can mutual funds run away with our money or become bankrupt?

Published: June 1, 2018 at 12:28 pm

Last Updated on

Are mutual funds safe? Can mutual fund run away with our money or become bankrupt? This should not be dismissed as a newbie question. It is one of the first and most important considerations before investing in a mutual fund. We certainly have instances in the past where fund managers could invest where they want, change from debt to equity and value the fund anyway they like UTI 64 debacle. Also, see this old outlook article. As usual, our administrators react (and not pro-act) after something “bad” happens and hence was born the SEBI MutualFund Regulations act 1996.

This post is inspired by two reasons: Thanks to a question by Dheeraj Barnwal at FB group, Asan Ideas for Wealth (not the first time a new investor has asked this). I am working on a 100 questions on Mutual funds e-book for new investors and this post will serve as a detailed answer to the titular question.

 Are mutual funds safe? Can mutual funds run away with our money or become bankrupt?

Short answer: Fact: They are a lot safer now than they were 22 years ago with high levels of transparency and stringent disclosure requirements.  If you are looking for a yes or no answer, then your question is wrong.

Can mutual funds run away with your money? Yes it is possible

What is the probability that mutual funds can run away with your money? Pretty unlikely. Why would they when they can earn handsomely from fund management fee? Please recognise the difference between possibility and probability!

Can mutual funds go bankrupt?   Any business can go bankrupt. this means that their expenses and debt are so high and profits so low that they cannot continue any more. The point to understand is that they cannot go bankrupt with our money!

While they invest our money, they are investing it for us and not for themselves. So if they get it wrong, the NAV can crash and we make a huge loss.  There are many funds which have destroyed investor wealth this way. Even then, the fund house will get paid via the expense ratio! So even a terrible mutual fund will make money as long as it has enough investors in it.

When a fund house repeatedly makes losses (this has nothing to do with the performance of their mutual funds), it will simply sell the business to someone else (willing to buy) or inform the investors that the fund is to be closed and return their money  = current value of units held.

Are mutual funds safe? Mutual funds are subject to ignorance risks. If you believe what the fund houses or sales guys say about the “benefits of mutual funds” without understanding investment risks, then they are not safe. If you started investing in mutual funds because of some ads in between an IPL match then they are not safe.

The risks associated with the stability and safety of the scheme are low thanks to SEBI regulations. The risks associated with investments are governed by how much you understand them. The point I am trying to make is: if you are worried that your money will vanish one morning then that is unlikely to happen. You should be worried about the possibility of your investment value diminishing overnight by 20% or 40% due to a market crash.

Do not cofuse saftey of the product with saftey of your investment!

Let us ask the right questions:

1: Will I know where a mutual fund invests its money? Yes via monthly disclosures. This is the full list of statutory disclosures

2: How do I know the NAV is correct? The valuation is strictly on market value and this is audited regularly. See presentation below.

3: How is my money protected? Mutual funds have a board of members known as the custodians whose primary job is investor protection. Custodians are responsible for keeping the fund securities safe and account for transactions.  They should not be affiliated with the sponsors of the MF company. Custodians are audited periodically and the report must be sent to SEBI.

The Registrars and Transfer Agents like CAMS or Karvy form a bridge between investors and the custodians. They handle customer compliance like KYC and process investments and redemptions. They are also periodically audited.

4: Can fund houses invest anywhere they like? No, there are guidelines by SEBI (see presentation below).  Also, they have to adhere to the pattern mentioned in the scheme document (which is pretty broad!). If they wish to deviate, they will have to inform investors and offer them a chance to exit without load.

5: Can fund houses invest any way they like?  No, there are guidelines by SEBI (see presentation below).  Also, they have to adhere to the pattern mentioned in the scheme document (which is pretty broad!). If you don’t like the freedom that fund managers enjoy as per the scheme document, then don’t use mutual funds.

Over the years SEBI has mandated several disclosures (linked above), got rid of exit load, introduced direct plans, introduced registered investment advisor regulations, limited the amount of stock and bond exposure in a fund, ruled that redemptions cannot be stopped due to the funds mistake, introduce new scheme categories, introduced and modified risk scales, made fund houses disclose commissions. So it has helped investors significantly.

Of course, some things have not worked, like investment advisor regulations which have done nothing to reduce conflict of interest,  Of course, it has also made unnecessary rules like making current investors pay for “investment awareness” which has been used for profit by the amcs.  Of course, there is room for improvement:  make commissions based on each invested value and not on market value (get rid of trail commission), ensure mutual fund salespeople do not offer investment advice ..

All said, SEBI has done a fantastic job in protecting mutual fund investors and it is a work in progress like anything else.

All of the above were short answers! If you want long answers, please take some time in reading the following two presentations from the western India regional council of The Institute of Chartered Accountants Of India. Save these two presentations in case, they are removed later.

Structure of a mutual fund and how the entities are audited

Easily the most comprehensive yet easy to understand resource on Internal Audit of Mutual Funds and Portfolio Managers

Do share if you found this useful
Share your thoughts on this topic at the  Reddit freefincal_user_forum

Reach your financial goals like a pro! Join our 1600+ Facebook Group on Portfolio Management! You can now reduce fear, doubt and uncertainty while investing for your financial goals! Sign up for our lectures on goal-based portfolio management and join our exclusive Facebook Community. The 1st lecture is free!
Want to check if the market is overvalued or undervalued? Use our market valuation tool (will work with any index!) or you buy the new Tactical Buy/Sell timing tool!
About the Author Pattabiraman editor freefincalM. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association. For speaking engagements write to pattu [at] freefincal [dot] com
About freefincal & its content policy Freefincal is a News Media Organization dedicated to providing original analysis, reports, reviews and insights on developments in mutual funds, stocks, investing, retirement and personal finance. We do so without conflict of interest and bias. We operate in a non-profit manner. All revenue is used only for expenses and for the future growth of the site. Follow us on Google News Freefincal serves more than one million readers a year (2.5 million page views) with articles based only on factual information and detailed analysis by its authors. All statements made will be verified from credible and knowledgeable sources before publication. Freefincal does not publish any kind of paid articles, promotions or PR, satire or opinions without data. All opinions presented will only be inferences backed by verifiable, reproducible evidence/data. Contact information: letters {at} freefincal {dot} com (sponsored posts or paid collaborations will not be entertained)
Connect with us on social media
Our publications

You Can Be Rich Too with Goal-Based Investing

You can be rich too with goal based investingPublished by CNBC TV18, this book is meant to help you ask the right questions, seek the right answers and since it comes with nine online calculators, you can also create custom solutions for your lifestyle! Get it now. It is also available in Kindle format.
Gamechanger: Forget Startups, Join Corporate & Still Live the Rich Life You Want Gamechanger: Forget Start-ups, Join Corporate and Still Live the Rich Life you wantThis book is meant for young earners to get their basics right from day one! It will also help you travel to exotic places at low cost! Get it or gift it to a young earner

Your Ultimate Guide to Travel

Travel-Training-Kit-Cover-new This is a deep dive analysis into vacation planning, finding cheap flights, budget accommodation, what to do when travelling, how travelling slowly is better financially and psychologically with links to the web pages and hand-holding at every step. Get the pdf for Rs 199 (instant download)
Free android apps