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Indian investors are increasingly embracing mutual funds for long-term wealth creation, thanks to campaigns like “Mutual Funds Sahi Hai.”
Yet, a nagging question remains: what happens if everyone pulls their money out of a mutual fund at once?
This fear materialized during the Franklin Templeton crisis in 2020.
Let’s explore what happens during a mutual fund panic redemption, how it differs from a bank collapse, and what safeguards exist to protect your investments.
Table of Contents
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1. How Mutual Funds Work
2. What Is Panic Redemption?
3. What Happens During Panic Redemptions?
4. Can Mutual Funds Collapse Like Banks?
5. The Franklin Templeton Example
6. Safety Measures Post-Franklin Crisis
7. How to Protect Yourself
8. Final Thoughts
1. How Mutual Funds Work
When you invest in a mutual fund, you’re pooling your money with other investors. A professional fund manager allocates this collective capital across a diversified portfolio of securities—equities, bonds, money market instruments, or a combination.
Unlike banks that promise fixed returns and principal safety, mutual funds operate on market-linked returns.
The Net Asset Value (NAV) reflects the fund’s daily market performance.
Investors benefit from capital appreciation and income distribution, but also carry the risk of market volatility.
It’s important to understand that you’re not lending money to anyone—you’re investing in an asset class that can go up or down in value.
2. What Is Panic Redemption?
Panic redemption occurs when a large number of investors withdraw their money from a mutual fund in a short span of time.
This usually happens due to:
- Fear of market downturns
- Poor performance of the fund
- Rumours or negative news surrounding the AMC
- Global financial crises or pandemics
While this might sound similar to a bank run, the implications are quite different.
Banks operate on leverage and provide guaranteed withdrawals; mutual funds do not.
But even in mutual funds, too many redemptions can cause systemic issues.
3. What Happens During Panic Redemptions?
A) Asset Sales
The fund manager starts selling securities to raise cash and meet redemptions. The most liquid and high-quality assets are sold first.
B) NAV Erosion
If the assets are sold under distress or below fair value, the NAV drops. All remaining investors see a decline in the value of their units.
C) Deterioration of Portfolio Quality
As good assets get sold off, what’s left in the portfolio tends to be less liquid or riskier instruments, potentially compounding the problem.
D) Redemption Spiral
Declining NAVs trigger more redemptions, further asset sales, and deepening losses. This creates a self-fulfilling loop of panic.
E) Suspension or Winding-Up (in extreme cases)
If redemptions are overwhelming and liquidity is dried up, the AMC may suspend withdrawals or wind up the scheme with SEBI’s approval.
4. Can Mutual Funds Collapse Like Banks?
Short answer: No. Mutual funds do not “collapse” like banks, but they can enter a state of financial stress if mismanaged.
| Aspect | Banks | Mutual Funds |
|---|---|---|
| Customer Type | Depositor (Loan to Bank) | Investor (Market-linked) |
| Capital Guarantee | Yes (up to Rs.5 lakh by DICGC) | No |
| Regulatory Body | RBI | SEBI |
| Failure Consequence | Insolvency, deposit insurance | NAV fall, redemption restrictions |
| Bailout Possibility | Yes (RBI or Govt.) | No |
Banks use your deposits to lend, which creates a leverage cycle.
Mutual funds are pass-through vehicles—investors bear gains or losses.
Hence, while a bank failure risks loss of capital (beyond insurance), mutual funds expose you primarily to market volatility.
5. The Franklin Templeton Example
In April 2020, Franklin Templeton India abruptly shut down six debt mutual fund schemes, impacting over Rs. 25,000 crores in investor assets.
The reason? A perfect storm:
- Heavy exposure to illiquid and low-rated corporate bonds
- COVID-19-led panic redemptions
- Virtually frozen bond markets, making it impossible to liquidate holdings
Though the fund eventually returned most of the money to investors, it served as a wake-up call on credit risk and liquidity issues in debt funds.
This incident highlighted the importance of understanding where your money is invested—not just the brand name of the AMC.
6. Safety Measures Post-Franklin Crisis
To restore investor trust and improve risk management, SEBI rolled out key reforms:
- Mandatory Liquid Holdings: Debt funds must maintain a buffer of liquid assets to meet redemptions.
- Portfolio Transparency: Daily disclosure of fund holdings for improved investor awareness.
- Credit Risk Caps: Limits on how much can be invested in low-rated papers.
- Duration and Risk Categorization: Clearer labelling of schemes to match investor expectations.
Many fund houses also shifted toward Target Maturity Funds (TMFs), which offer better predictability and hold high-quality G-Secs.
These changes have made debt funds more resilient, but not risk-free.
7. How to Protect Yourself
i) Check Portfolio Quality
Always look into the fund’s holdings—avoid schemes with high exposure to low-rated or unrated bonds.
ii) Prefer High Liquidity
Funds investing in government securities, treasury bills, or AAA-rated debt offer better liquidity during tough times.
iii) Match Investment Horizon
Use liquid and ultra-short duration funds for short-term needs; opt for longer-duration funds only for long-term goals.
iv) Diversify Across AMCs and Categories
Don’t keep all your debt investments in one fund or one AMC. Diversification reduces overall risk.
v) Avoid Panic Selling
Panic selling locks in losses. If your investment aligns with your financial goal and time horizon, stay put.
vi) Review Regularly
Monitor fund performance and credit exposure periodically. Don’t set and forget.
Final Thoughts
Mutual funds offer great potential for wealth creation but come with market risks.
While they don’t “collapse” like banks, panic redemptions can cause temporary disruptions, erode NAVs, and delay fund access.
The key is preparation, not panic.
Knowing what your fund holds, maintaining a diversified portfolio, and matching investments with financial goals can help you stay calm during turbulent times.
To make informed, objective investment decisions—especially when emotions run high—consider working with a Certified Financial Planner (CFP).
A CFP can help you build a resilient strategy tailored to your goals and guide you through uncertain markets with confidence.
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