The Hindu Business Line : Fund Talk

I read reports that some AMCs do not have funds to meet the pressure of redemption on their funds. Funds are understood to be raising money at exorbitant rates to meet redemption pressures and that this would affect remaining investors. Is this a fact? How should I respond to this?

S. Gupta

Some AMCs did face premature redemption requests on their Fixed Maturity Plans (FMPs) over the last two months. To meet these demands, fund houses did borrow at high rates from the banking system. These borrowings were made necessary by a liquidity crunch faced by funds, on account of unexpected redemptions. The situation has improved since, as interest rates have declined and the RBI too has intervened to meet liquidity needs of the industry. But even so, as an investor, you have little to worry about losing your investment through a mutual fund `running out of funds' or failing to honour redemption requests.

The very structure of the mutual fund industry ensures that the money that you invest in a mutual fund is separated from the AMC's own capital or expenses.

NAV-BASED PRICES

Funds promise to honour redemption requests from investors based on their prevailing NAV. On redeeming investments, you can be sure that a price close to the NAV is what you will get.

The NAV captures the current value of your investments in the fund, with all the portfolio gains/losses and income/expenses on the portfolio factored into it. The calculation of the NAV and the expenses that can be charged to it, are defined by SEBI regulations. Expenses to be incurred by a mutual fund are also capped at specific limits (2.25 per cent of average net assets for debt funds and 2.5 per cent for equity funds). Therefore, even if funds did incur a high borrowing cost in servicing redemptions, this cannot be entirely charged off to the scheme, thus impacting remaining investors.

Having said this, as an investor, you have reason to worry about the hidden costs of redemptions, only if the fund you own invests in illiquid securities. This risk is present for closed end funds, particularly in the debt category. (As open end fund managers have to be prepared to meet redemption demands from investors at all times, they would not venture to invest a significant portion of their corpus in paper that cannot be sold at prevailing market prices). Premature redemptions from an FMP, which is supposed to be a closed end fund running for a fixed term, can be detrimental to remaining investors.

The fund's NAV (and thus your returns) will be impacted if the fund is forced to liquidate its debt paper at a steep discount to market price and if the exit load fails to compensate for such a discount.

SPOTTING REDEMPTION

Therefore, after recent events, investors in FMPs must check back on their funds for signs of significant redemption. How can you spot this?

Requesting your fund to disclose its portfolio and net assets at the end of the last two months, will give you a clear picture. A very sharp decline in the total net assets can be a sign that the fund saw significant outflows. A small decline in this number (say, less than 10 per cent) may not be a cause for worry. This could be caused partly by market-to-market losses on the portfolio, which will be made up when the fund completes its term. Checking on the figure for "unit capital" disclosed in the half yearly accounts published by mutual funds for September (available on fund websites and newspapers) is another way. A sharp decline in unit capital shows pullouts from a fund.

But do not redeem your mutual funds investments just because other investors have done so. If you own debt funds, redeem only if you have concrete evidence that the fund's performance is slipping sharply or that its portfolio has deviated quite a bit from what you expected. If you are a conservative investor who invested in a FMP as a substitute for a fixed deposit, you may not be comfortable with a portfolio that has sizeable exposures to debt rated less than Triple-A. Remember, premature redemption from a FMP will mean settling for lower returns than you originally planned. When you redeem a FMP at NAV-based prices, you will pay an exit load and also forfeit a portion of the returns that may yet accrue at maturity.

We are not sure if your query pertains to equity or debt funds. Unless you need your money within the next one year, this would be a particularly bad time to exit equity funds. Not only would you be bearing big losses on your investment (if you invested over the past two years) due to the market fall, you would also forego any opportunity to obtain better NAVs, which is likely if the market stages a recovery from current levels.

Given the magnitude of the fall and the low valuations at which stocks are now trading, such a recovery is quite probable over a 2-3 year time frame.

AARATI KRISHNAN

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