Mutual Fund Myths That Need to Be Corrected by Investors

What we need to keep in mind when we hear ‘mutual funds are always safe,’ or ‘mutual funds are always liquid.’

Mutual funds are an integral part of the portfolio of most investors. This situation will continue going ahead as mutual funds represent an easy and cost effective way to build a strong portfolio.

Investors though will need to exercise additional due diligence while making their investment choices. Several things that are often told to investors to lure them towards mutual funds need proper understanding and revision.

Here are some of them:

Debt Mutual Funds Are Safe

There is often an attempt made to distinguish between equity-oriented mutual funds, that invest in shares, and debt mutual funds, that take exposure to debt instruments like bonds, debentures, government securities etc.

Debt mutual funds are touted to be safe and most investors think of them as an alternative to other debt instruments like fixed deposits or small savings instruments.

However, debt mutual funds have their own risks in the form of credit risk, which is that the issuer of debt will not repay the money or interest rate risk which is that interest rates might move against the fund managers’ expectations.

All this has come to the fore in the last year or so and investors need to be aware of the risks that each specific debt fund carries, so that they are not shocked when these risks crop up.

Mutual Funds Are Always Liquid

The liquidity provided by mutual funds is a very positive factor because the investors can go and get their money back whenever they want. However, this liquidity is present only as long as things are normal. In times of crisis, this liquidity can disappear as mutual funds evoke specific clauses, as has been seen in the Franklin Templeton case.

Here, investors found that several funds were wound up overnight and their money stuck without any way for them to access the money till the mutual fund returns the amount. Sometimes, even close ended funds find no buyers on the stock exchanges so here too liquidity becomes an issue.

Diversification Protects the Portfolio

Diversification is one of the best way to reduce the risk in the portfolio and mutual funds hold multiple securities to gain the benefits of this principle. However, even this is no guarantee that the investor will be protected.

This has been seen in several debt funds where the Net Asset Value has crashed anywhere between 17 percent to 50 percent in a day, as holdings were marked down to reflect the reality of the investments held.

Diversification does not work when a large part of the portfolio is affected by some event and that is what is being witnessed by investors.

Debt Fund Movements Are Small

Normally, equity is expected to be a volatile asset class and debt a stable asset class. The normal expectation is that debt funds will see a slow and steady movement to generate returns for investors.

While this remains mostly true, it has been seen that the movements are often sharp in debt funds due to defaults or other problems in the holdings.

This sharp change can be even more than what is usually seen in an equity mutual fund. In addition, a 3 to 4 percent movement in a debt fund could mean a wipe out of half a years return, so the changes in the debt fund also have to be taken in perspective.

Long Term for Equity Funds

Equity funds are impacted by the performance of the equity market. Most investors think of 3 years as being long-term because it seems like a pretty long period of time. However, for equity oriented mutual funds, the long term could turn out to be 7 to 10 years.

Thus, it could be a very painful period for investors when they find that their returns seem to be going nowhere.

This is especially true during tough times, when even the outlook is bleak. But investors need to stay disciplined and hang on to their investments for the results to actually show.

(The writer is Founder of Moneyeduschool)