If you thought that investing in mutual funds is risky only because they invest your money in risky investments, think again. There are risks involved with the manner in which the NAV is calculated and in the way in which the mutual fund organises its work.

The risk that arises because of the way in which the NAV is calculated

Mutual funds invest in a number of securities, some are listed in stock exchanges, while others are not. For example shares are listed, some debentures are listed, etc. While fixed deposits given to companies are not listed on stock exchanges. As far as listed securities go, it is relatively easier to find value of the investment – it is the last quoted price on the stock exchange.

The real problem comes in trying to value the non-traded or thinly traded investments. Mutual funds have no way of knowing the “value” of such investments on a daily basis, which is required to calculate the NAV. One does not know the exact status of the company’s financial status on a daily basis, or have a knowledge of the various decisions that affect value, that are being taken within the company etc.

To overcome this problem the exercise of valuing non-traded shares is given to an external agency – very often a credit rating agency. Credit rating agencies make many mistakes. In the recent past they did not foresee, for example, the financial crisis of IL&FS. Credit rating agencies are outsiders to the company and will not have access to accurate information. Even the statutory auditors did not foresee the problems of IL&FS, when they had access to all data and documents.

Hence when companies like IL&FS, Dewan Housing started to default, investors in those companies started to lose money. The risk in this instance is not the risk of operating in those sectors (Infrastructure and Housing Finance), which carries its own risks. It is the risk of making wrong valuations, because of which the NAV is highly exaggerated and kept at unrealistically high levels. The investor thinks (without knowing all the mis-calculations that went into showing a high NAV) that the NAV is high and continues to hold the investment or even invest more money. Finally when the cat is out of the bag, the investor loses money.

The Risk in the way mutual funds are organised

Today we will stick to only one organisational issue that creates risk in a mutual fund.

Fund Managers in a mutual fund are paid incentives based on the performance of the fund they are managing. On paper this sounds quite fair. In principle, the fund manager is being told by the mutual fund: You give good returns to your investors, you get paid well.

In practice however this works in a different way. Fund managers know the better the performance of their fund, the higher their incentives will be. So they take more risks in where the fund’s money is invested, in the fond hope the more the risks they take, the better the fund performance will be and consequently they will earn a very good incentive.

The fundamental aspect of risk is that you can earn more money by taking more risk, but you can also lose all your money by taking those higher risks. More risks does not guarantee higher return. But in an incentive driven work environment, the fund manger takes to investing in low rated securities, in fixed deposits of companies whose financial position is weak but are promising 12 % or more when the market rate is 8 %, etc. The fund managers also invest in small cap and mid cap in the hope of earning more incentives.

Risk is Kaleidoscopic

Hence risks in mutual funds have many colours – most of which are hidden from the investor. In most cases investors do not know what they are getting into. Risks such as those explained in this article explain why the mutual fund investor has been earning low returns through 2018 and 2019 on mutual funds – whether debt or equity.

Sell Risks not Returns

Sell risks not returns. Explain investment risk to your customers. Indians are basically a low risk appetite investors. When your customers are adequately educated by you on the meaning and implication of investment and the variety of ways it can surface in future, most customers will keep away from high risk investments. Because returns are uncertain, risks are certain.