Explaining risk in mutual funds to investors remains a challenge. Investors ask for a minimum return that is preferably better than the interest on bank deposits. They dismiss the idea of return compared to a benchmark. Underlying the persistent misconceptions about mutual funds is the poor understanding of risk in a mutual fund compared with that in a bank.
Risk is the possibility that actual returns will be different from what was expected. It primarily arises when investors' money has been put in assets that do not perform as expected. However, forming realistic future expectations for returns is tough. Therefore, investors prefer products where the return is indicated upfront. Bank deposits are simple products to buy because the interest that will be paid is stated upfront.
How is this promise made and how is it kept? Banks issue deposits and generate returns from loans. For example, when a bank borrows at 8 per cent and gives out a loan at 11 per cent, its ability to pay interest on the deposits depends on the loans being repaid as promised. Since it is not possible to create the perfect loan portfolio that will never default, how do banks ensure that this risk is not passed on to the depositor?
Banks are not allowed to fund all their loans with deposits, but must bring in equity capital to absorb possible losses on the loans they offer. Banks are subject to capital adequacy norms, where the amount of equity capital they should have must be linked to the risk of their loan assets. This is why when we look at the poor quality of loans on the books of banks today, we worry about how the equity capital will be found and who will provide it.
In a mutual fund, the investors' money is deployed in a portfolio. Here the investor is not a depositor, but an equity investor. Therefore, the return to the investor depends on the value of the portfolio. While a bank depositor does not know the portfolio of loans or may not care about the price of the bank's equity shares, a mutual fund investor needs information.
A mutual fund investor not only knows the NAV on a daily basis and the portfolio on a monthly basis, but can also act on this information and decide to leave the fund if he is not willing to take the risk of the assets in which the fund has invested. So, in both cases, the asset portfolio is risky.
Bank loans can go bad and mutual fund securities can lose value. How this risk is managed is very different in both cases. In a bank, processes are put in place to evaluate a borrower before giving a loan and collateral may be sought to support the loan. The bank will recognise a loan as non-performing when the interest is not paid on time. It will then provide for the loan as bad debt by writing it off from its profits. The bank uses its books to manage the risk after it has manifested.
A mutual fund will invest in assets at market prices using a selection process. However, as the asset's risk changes, its price will change. This, in turn, reflects on the NAV. Since market prices reflect the expectation for asset performance, mutual fund NAV reflects expected risks even before the event has taken place. Investing in a mutual fund means investing in a market portfolio that is dynamic, but also volatile.
How do these differences impact the investor? In a bank deposit, the investor primarily bears a credit or default risk. If his bank is well-capitalised, follows prudential processes for offering loans and recognising any deterioration in quality, this risk is mitigated. In a mutual fund, the investor bears a market risk. If the securities in which the mutual fund has invested fall in value, the investment is at risk. Hence, a mutual fund diversifies its holdings so that the portfolio's value is not swayed by a single
. However, the market risk remains because it is not possible to construct a zero-risk portfolio, whether it is made up of loans or securities.
In a mutual fund, the investor is an equity investor in the fund and earns whatever is made in the portfolio. To protect such investors, it is important to ask for the portfolio to be diversified, transparent, liquid, and valued correctly. This is what the mutual fund regulation in India and elsewhere ensures.
Additionally, the assets of the fund are held in custody by a third-party bank so that there is no misappropriation. In a bank, the investor is a lender to the bank and earns a fixed rate of interest. To protect such investors, regulators require banks to risk-weight the assets (loans), subject banks to strict supervision, and ask for adequate disclosures. The Basel norms for banks rests on these three pillars.
What if the mutual fund is also capitalised? To impose a capital adequacy on mutual funds, it is important to define the return that the investor is entitled to. In a bank, the liability to the depositors is pre-defined. Therefore, it is possible to define the capital adequacy as a percentage of assets. In a mutual fund, the return to the investor is the value of the portfolio itself. This value does not change around a defined level, but can move on an everyday basis, depending on market prices. So, even if we ask for another layer of equity investors to come in and contribute capital, it is not possible to define how the gains or losses on the portfolio will be split between the investors and capital providers. This is why ideas, such as minimum capital requirement or seed capital for mutual funds, are conceptually wrong and inequitable.
Instead, what we should ask for is an independent yardstick of how much return the mutual fund should have earned, and if it did better or worse. The benchmark serves this purpose. Every fund has to state the market benchmark that reflects the portfolio composition it seeks to create. For the fee it takes, it should beat that benchmark. That is the demand investors must make on mutual funds.
Research shows that several funds fail to do this. That should be the focus of investors and regulators. Not the tiresome tirade of asking why mutual funds cannot work like banks, or why they cannot be capitalised.