Investors need to focus on whether a mutual fund is beating its benchmark, instead of asking why it can’t work like a bank or be capitalized.
Uma Shashikant | Apr 14, 2014, 06.16AM IST | Times Of India
Explaining risk in mutual funds to investors remains a challenge. Investors ask for a minimum return that is better than the interest on bank deposits. They dismiss the idea of return compared to a benchmark. Risk is the possibility that actual returns will be different from what was expected. Forming realistic expectations for returns is tough. Therefore, investors prefer products where the return is indicated upfront, as in the case of bank deposits. 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% and gives out a loan at 11%, its ability to pay interest on the deposits depends on the loans being repaid as promised. It is not possible to create a portfolio that will never default. So, 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. They must comply with 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 exit 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. This risk is managed differently in both cases. In a bank, processes are put in place to evaluate a borrower and collateral may be sought to support the loan. The bank will treat a loan as non-performing when the interest is not paid on time. It will then write off the loan as a bad debt. The bank uses its books to manage the risk after it manifests.
A mutual fund invests in assets at market prices. As the asset’s risk changes, its price will change, which reflects. 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 does this 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 value of the securities in which the fund has invested falls, the investment is at risk. Hence, a mutual fund diversifies its holdings so that the NAV is not swayed by a single security. However, it is not possible to construct a zero-risk portfolio.
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 that the portfolio is diversified, transparent, liquid, and valued correctly. Additionally, the assets must be held in custody by a third-party bank so that there is no misappropriation. In a bank, the investor is a lender and earns a fixed rate of interest. To protect such investors, regulators require banks to riskweight the assets (loans), subject banks to strict supervision, and ask for adequate disclosures.
What if the mutual fund is also capitalized? To impose a capital adequacy on mutual funds, it is important to define the return that the investor is entitled to. The return to the investor is the value of the portfolio itself. This value can move on an every day 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 is supposed to have one. For the fee it takes, it should beat that benchmark. 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 capitalized.