Know the Various Implications of Liquidity Risks in Mutual Funds

Published On: 11-Sep-2020

While you might have heard a lot of about the common risks of investing in mutual funds, risk due to liquidity is rarely talked about. Read this post to know what it is and why is it so important for every investor. 

If you're new to mutual funds and still educating yourself, you might have surely come across a lot of information about the common risks. From market volatility, interest rate risk, credit risk, concentration risk, there are a lot of things that you should know about; before you start your investment. But while you may easily come across articles and blogs talking about these common risks, not a lot of them talk about the risk of liquidity in mutual funds.

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There may be many different causes of liquidity risk, but the most common reason is when a mutual fund invests in securities that are not easily or frequently traded on exchanges. In such cases, an AMC might have to incur a substantial cost for converting these securities into cash.

If this is the first time that you’re reading about the risks due to liquidity in mutual funds, here are some of the most important things you should know-

1. How do AMCs ensure liquidity?

There are different ways in which an AMC tries to keep the risk of liquidity at a minimum. For instance, a lot of AMCs hold adequate cash position to keep up with the daily transactions of the fund.

Also, the AMCs try to maintain a healthy balance between the inflow and outflow of funds to avoid any kind of risks due to liquidity. Redeeming matured bonds and reinvesting interest and dividends are two other ways for ensuring adequate liquidity.

2. Types of funds more prone to liquidity risk

While most mutual funds in India are liquid, there are a few types of funds that are more prone to the risk as compared to others. For instance, close-ended credit-risk funds often have a higher risk as the chances of default are high. Also, funds that invest in low quality bonds are at risk too. 

When selecting mutual funds, especially debt funds, make sure that you check the portfolio of the fund to pick safer funds.

3. Buy-Back from Fund House 

As per the SEBI regulations, every close ended scheme shall be listed in a recognized stock exchange within six months from the closure of the subscription. Repurchase of close ended schemes: Units of a close ended scheme, other than those of an equity linked savings scheme, shall not be repurchased before the end of maturity period of such scheme. The units of close ended schemes as referred above may be open for sale or redemption at fixed predetermined intervals, if the maximum and minimum amount of sale or redemption of the units and the periodicity of such sale or redemption have been disclosed in the offer document.

Most of the AMCs rarely provide buy-back offers and prefer listing the fund on an exchange. But due to lack of buyers and sellers, the liquidity risk remains.  

4. Fluctuations in NAV

Ever saw the price of a stock that is not regularly traded on the exchange? The price of the stock is highly volatile and may change significantly with every buy or sell order. The same is true for a fund struggling with liquidity. 

The liquidity pressure makes such funds riskier and they often experience higher NAV changes on a regular basis. This makes liquidity risk management so crucial for mutual funds.  

5. How investors may avoid the risk due to liquidity?

Investors need to understand the tenure of the close-ended schemes before making an investment decision. If the investor decides to invest in a close-ended mutual fund, the investor should make sure the close-ended scheme is aligned to his/her financial objectives. 

The fund should be regularly traded on the exchange with decent trade volumes. It should not have junk bonds or highly risky credit instruments in the portfolio. 

Conclusion

While mutual fund liquidity is not quite a significant concern for most types of funds, you should be extra cautious if you're planning to invest in close-ended funds.  

A lot of times the negative impacts of the liquidity risk come announced, making it very important for the investors to closely track the performance of these funds if they do decide to invest in them. 

DISCLAIMER:

The information in this document is provided for information purposes only. It does not constitute any offer, recommendation or solicitation to any person to enter into any transaction or adopt any hedging, trading or investment strategy, nor does it constitute any prediction of likely future movements in rates or prices or any representation that any such future movements will not exceed those shown in any illustration. Users of this document should seek advice regarding the appropriateness of investing in any securities, financial instruments or investment strategies referred to on this document and should understand that statements regarding future prospects may not be realized. The recipient of this material is solely responsible for any action taken based on this material. Opinions, projections and estimates are subject to change without notice. 

UTI AMC Ltd is not an investment adviser, and is not purporting to provide you with investment, legal or tax advice. UTI AMC Ltd or UTI Mutual Fund (acting through UTI Trustee Company Pvt. Ltd) accepts no liability and will not be liable for any loss or damage arising directly or indirectly (including special, incidental or consequential loss or damage) from your use of this information, howsoever arising, and including any loss, damage or expense arising from, but not limited to, any defect, error, imperfection, fault, mistake or inaccuracy with this document, its contents or associated services, or due to any unavailability of the document or any part thereof or any contents or associated services.