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Last Updated : Sep 22, 2016 06:58 PM IST | Source:

Why mutual funds do not guarantee returns? And why is it good?

Though guarantee is a sought after factor for many investors, it still makes not to go for it.

Amit Trivedi

In the world of investing, “guarantee” is such a sweet sounding word. If the returns are guaranteed, what else does one want? Well, one may still want these returns to be high and tax-free.

But that is deviating from the main point. Investors love guarantee. And mutual funds do not offer guaranteed returns. This could be one of the reasons why it is not the first choice for many. At the same time, it also calls for increased efforts towards investor education on what mutual funds really are and can do.
So, let us address that question first: What is a mutual fund?

A mutual fund is an investment avenue, one might say. Incorrect. A mutual fund is not an investment by itself, but it is a vehicle to invest in various avenues. The money that we put in a mutual fund is invested by professional fund managers in line with the objective of the scheme.

The performance of these investments impacts the returns generated by the mutual fund scheme. The deciding factors are: the movement of the specific market in which the money is invested, the performance of individual securities held and the skills of the investment management team. Out of these, the fund manager can work towards improving one’s skills, but the other factors are out of his control.

Considering that the returns generated by the markets cannot be guaranteed, the fund does not guarantee any returns to the unitholders.

However, many people ask why even debt or liquid mutual funds cannot guarantee returns, while these funds invest in guaranteed return products like fixed income securities? Well, the reason is simple. For that, we need to understand what kind of guarantee we get in case of fixed income products.

We get guaranteed returns in case of fixed income products only if
1.    The issuer is Government of India, which would not default on its commitment towards the Indians.
•    In case of any other issuer one cannot rule out the possibility of inability to return the investor’s money – also known as credit risk or risk of default.
2.    We hold on to the investment till maturity.
•    In case of selling it out before maturity, some instruments have a penalty clause or those you are able to sell in the market get sold at market price – an unknown.
3.    The investment’s maturity exactly matches with our own investment horizon
•    In case your time horizon is longer than the maturity period of your investment, you do not know at what rate of interest you would be able to invest the maturity proceeds.
4.    You do not take any regular interest payments
•    As you can see, the interest payments that you receive need to be reinvested back to get the benefit of compound interest. Once again, it is impossible to predict the rate of interest available when you receive these interest payments.

In other words, it is a fixed income instrument that may offer guaranteed return for the period for which it is issued, provided the entire interest is received on cumulative basis and the issuer honours the commitment. This also means that you do not know how much return you would get over your own lifetime through a portfolio of different fixed income investments.

A fixed income mutual fund is a portfolio of fixed income securities. Hence, the portfolio’s returns cannot be guaranteed.

At the same time, if the mutual fund were still to offer guarantee, it would need to absorb all the fluctuations in the returns it generates. That would require the fund manager to estimate the portfolio return and then keep some margin of error and guarantee the returns. This would mean lower returns due to the margin of safety. This would also mean that the mutual fund carries credit risk – the risk of default. In case of a mistake by the fund manager, or default by a company that the fund has invested in, the fund would default on its obligations towards the investors.

Also, in order to offer guarantee, the mutual fund would need to be close-ended fund. An open-ended fund cannot guarantee returns to an investor, since different investors can come in at different times, as well as get out as per their requirements.

The structure of mutual funds is that it is a pass-through vehicle and passes on the risk and return to the fund’s investors. That itself protects the interests of the investors. A mutual fund is not a guaranteed return product. It is just another way of managing your money – except that instead of you; it is a professional fund management team that takes care of your money.

Happy investing!

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.
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First Published on Sep 21, 2016 06:32 pm
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