Whenever a mutual fund or an asset management company gets into trouble (bond defaults, front running, etc), some investors say, “They want their money back!” But will they get it? Some even believe SEBI will bail out investors. Is this true?
The short answer is, nope! You had purchased units from the mutual fund company. When you redeem, you would like the AMC to buy back those units at the current market value. So, your “principal” is not secured in any way. In that sense, you will not “get your money back” if mutual funds get into trouble.
When you invest in a mutual fund, you buy units at a particular market value after all expenses (including commissions) are deducted, known as the NAV (net asset value).
For example, if the current NAV is Rs. 929.329 per unit, you invest Rs. 50 lakhs (why think small? We are only thinking!). you will be allotted 50,00,000/929.329 = 5380.226 units.
When you request a redemption, the units’ age and current market value determine your actual gains (or losses).
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If the current NAV of those 5380.226 units is 557, and you wish to redeem all the units, you will get a grand sum of 29.96 Lakhs (exit loads will also apply!).
So, there is no way you can get your “principal” back if the current NAV is lower than the NAV when you purchased the units. SEBI can do nothing more here!
In a crisis, the most significant risk to the mutual fund investor is the mutual fund investor themselves! Typically, a mutual fund will hold small cash and money market bonds to handle redemptions and purchases. They will use this ‘cash or cash equivalents’ to distribute money to those who wish to redeem or accumulate some cash until they can buy more stocks or longer-term bonds when the purchases come in.
When many investors suddenly wish to pull out due to a crisis or a fear of a crisis, the fund manager will be forced to sell the core portfolio holdings (stocks or bonds) to handle the redemptions.
Since they are forced to sell quickly, depending on the liquidity of the stock or bond and its impact cost in the market (volume-dependent difference between the bid price and sell price), they have to incur a loss. This will show in the NAV as a fall.
As more and more investors head to the door, the NAV will fall more and more. This is known as redemption risk. Franklin closed six funds because of such redemption pressure (it could not sell its bonds in the market).
So unlike bank deposits where there is limited deposit insurance, mutual fund investors are subject to market risks! Please read the scheme documents before investing! And don’t expect the regulator to bail you out.