The newspaper Mint reported on 4 December 2018 (MFs extend loans to listed entities against shares in promoter firms by Jayashree Uphadhyay and Gopika Gopakumar) that some of the mutual funds have extended loans directly to companies. Some of mutual funds that have been mentioned in the article are: Franklin India Ultra Short Bond, Reliance Ultra Short Duration Fund, Aditya Birla Sunlife Medium Short Term Plan, amongst others. On the face of it there is nothing wrong in mutual funds making such investments if it is in line with the objectives stated in the Offer Document, and the statutory disclosures are made.

The difficulty arises when we want to assess the risk in the mutual fund. Mutual funds in general are risky. But the degree of risk depends on where the MFs invest the money collected from investors. For example the funds mentioned above have been created for investments in short term securities. The duration of such investments is usually in days, or months and maximum 1 year. Mutual funds investing in short term investments are generally taken to be less risky than those that invest in securities that have longer maturity periods. The general perception of short term mutual funds is that investment is mostly in the short term bond or cash markets, which are relatively less risky, with less volatility. But if the mutual fund invests directly in companies, the scenario becomes quite different. It is no longer less risky, in fact it enters the category of very high risk. There are four main reasons for the change in the risk category of the mutual fund.

Firstly, the loan given to a company is not a trade-able security. Suppose the fund invests in 91-day G-Secs. The G-Sec is trade-able. In the event of a market downturn, the investment manager can, if required, sell the G-Sec. But that is not the case with a company loan, In case the company does not pay the interest or the principal, the mutual fund will only have to wait for things to get better. There is no guarantee that things will get better. Usually for a company that is failing, things do not get better.

Secondly, while there is disclosure (that the loan has been given and taken) in both the mutual fund as well as the company receiving the loan, there is no information on the use that the money is being put to. The newspaper article referred to above has raised the point on whether the sums lent to the company by the mutual fund is being put to business use or for the personal use of the promoter. This possibility enhances the risk in the investment.

Thirdly, there is a risk that the loans are being given to the promoters or the company without a corresponding pledge or mortgage. Even where there is a mortgage or pledge, it is very difficult to recover from the promoter or company if they are under financial stress. This fact is borne by the current problems that banks are having in recovering nearly Rs.10 lakh crores of money from their borrowers. Banks are at best expecting to recover about 10 to 15 % of Rs. 10 lakh crore due to them!

Fourthly there is a question of who is being given the money on loan. The newspaper article quotes instances of the loan being given to an investment company of a large business group. The investment company manages investments for all the group companies. In this instance the mutual fund does not even know which business the money is being used for. As a consequence, the mutual fund is in no position to assess the risk of its lending. Such lending is a very high risk, since the mutual fund has no say on where the money is going to be utilized.

Mutual funds are appropriating the role of banks. They have neither the expertise nor the knowledge of such financial activities. They are exposing the investors to a very high risk. The investors are not even aware of the type of risks nor the extent of risk they are being exposed to.

The investor in a mutual fund blindly invests in good faith. Directly investing in companies and not in financial securities such as debentures or government securities or shares amounts to misuse of the good faith that investors have reposed in the mutual fund. A debenture for example is issued by the company for a purpose that is indicated in the Prospectus at the time of issue and is whetted by SEBI, the merchant bankers, etc. Subsequent disclosures on a regular basis indicate whether the money is being used for the purposes it was taken. All such controls do not exist where mutual funds lend directly to the company.

This is another reason to stay away from mutual funds. Apart from the risks of financial markets that investors are bearing (and those with the risk appetite choose to do so knowingly), there are hidden risks that investors are not aware of. In bad times such hidden risks can wipe out all your investment in mutual funds.

Do remember to mention this to your customers. You will be doing them a favor for which they will be obliged to you.