Are Mutual Funds Safe?

From Outlook Money

Although they come without any explicit guarantee of capital protection, mutual funds can give the investor peace of mind

Every investor wants to protect his capital and aims for a reasonable return on his investments. The question, then, is: do mutual funds (MFs) meet these criteria? Being subject to market risks, MFs do not guarantee capital preservation. However, there are plenty of safeguards built into the system to protect the interests of investors and their money. Let’s take a look at some such features.

The Safeguards

Structural Safeguards. The capital market regulator, Securities and Exchange Board of India (Sebi), which regulates MFs, is a critical entity in protecting investor interest, be it by drafting regulations or monitoring their implementation. It has laid down guidelines for all constituents of an MF, like sponsors, trusts, asset management companies (AMCs) and custodians.

Mutual funds provide the benefit of diversification that helps minimise the impact of volatility

Regulations pertaining to sponsors and trustees are crucial to protecting investor interest. For instance, to be the sponsor of an MF—the sponsor of an MF is what a promoter is to a company—one needs to have at least five years of experience in the financial services business, three of which should have been profitable. This ensures a minimum track record for the sponsor, whose expertise should give investors comfort.

The board of trustees, which is set up by the sponsor, also aims to protect investor interest. At least two-thirds of the directors on the board are required to be independent. This helps in maintaining an independent stance, albeit slightly tilted in favour of investors. Trustees also monitor fund performance and compliance with Sebi regulations. The trust holds the investors’ money in fiduciary capacity. The Sebi MF regulations, 1996, give the trustees immense power. In case of continuous underperformance and unethical practices, trustees can even dismiss the AMC.

Regulatory safeguards. Sebi’s investment guidelines add another layer of protection. For instance, an equity MF scheme cannot account for more than 10 per cent of a company’s paid-up capital. Similarly, a debt scheme cannot invest more than 10 per cent of its corpus in unrated debt instruments issued by a single issuer, and the total investment in such instruments cannot exceed 25 per cent of the scheme’s net asset value (NAV). These stipulations go quite some way in making the investments more secure. Besides, Sebi has introduced a slew of changes over the last two years, which includes making the Scheme Information Document available to the investor. Also, scheme-related documents now provide detailed information on fund policies, risks, trustees and operations. Some other changes that Sebi wants to introduce aim to bring in standardisation and transparency in disclosures by MFs. Apart from these in-built structural and regulatory features for safety of investments, there are three other aspects reinforcing this effect.

Benefits Of Diversification

MFs provide the benefits of diversification that help any investment to minimise the impact of volatility and earnings risk as opposed to investing in individual securities. One can diversify across asset classes—equity or debt—and across companies and sectors.

Wide product range

You can invest in MFs according to your risk appetite. If you are risk-averse, you may go in for debt funds or a combination of debt and equity, such as monthly income plans and balanced funds. Those willing to take risk for the sake of greater returns may go for mid-cap or sectoral funds.

Risk management

Apart from the benefits of diversification and a wide product range, MFs have another safety feature. Each AMC has its own internal risk management teams comprising risk analysts, who monitor risks and keep them in check.

To sum it up, an investor who is well-informed about product features can look forward to investing in MFs with confidence.