📚 PASS Investment Adviser (Level 1) Difficulty: Beginner ℹ️ Info   ~5 min read
📌 Chapter 11.8 — Process associated with Investment in Mutual Funds

Imagine you are reviewing a portfolio recommendation for a client who maintains a significant allocation in a corporate bond fund. As you analyze the portfolio’s underlying assets, you notice a surge in lower-rated paper and a narrowing of the liquidity buffer. While the fund technically offers T+2 redemption, you realize that a sudden market-wide credit event could force the fund manager to sell illiquid assets at deep discounts or, in an extreme scenario, impose redemption gates.

This realization shifts your risk assessment from a simple evaluation of yield to a critical analysis of asset-liability mismatch.

Liquidity risk in mutual funds arises when the ability to convert assets into cash is impeded by market conditions, creating a gap between the fund’s promised redemption window and the reality of the underlying security markets. In India, most open-ended funds provide daily liquidity, which functions seamlessly during normal market periods.

However, when a fund holds significant portions of its portfolio in illiquid securities—such as unrated corporate bonds or thinly traded debt—it relies on the assumption that investors will not all withdraw their capital simultaneously. If a liquidity crunch occurs, the fund may be forced to mark down the value of these assets, impacting the Net Asset Value (NAV) for remaining investors.

For a financial advisor, understanding this risk is essential for client suitability. If you recommend a fund to an investor who needs capital for an imminent liability, such as a child’s education fee, you must ensure the underlying portfolio is highly liquid. A fund that invests in long-duration or credit-heavy debt, while potentially offering higher returns, exposes the client to the risk that their capital may be locked precisely when it is needed most.

This is not just a theoretical concern; regulators in India have empowered fund houses to restrict redemptions during systemic crises to prevent a ‘run on the fund’ scenario, which can be catastrophic for retail participants.

Consider the contrast between a Liquid Fund and a Credit Risk Fund. A Liquid Fund is mandated to hold short-tenure, high-quality instruments to ensure near-instant access, whereas a Credit Risk Fund inherently trades off liquidity for higher yields. As an analyst, you must verify the ‘Liquidity Ratio’ of the portfolio and the concentration of the top ten issuers. If the portfolio exhibits high concentration in illiquid sectors, the risk of redemption delays during market stress increases significantly, regardless of the fund’s official promise of liquidity. 1

Nuance

⚠️ Nuance
Candidates often fall into the trap of equating ‘NAV availability’ with ‘guaranteed immediate liquidity.’ It is a common misconception that because a fund calculates its NAV daily, it can always satisfy all redemption requests without friction. A professional must recognize that liquidity is a function of the underlying asset market, not just the administrative processing capability of the R&T agent, and that regulatory intervention can legally override the standard redemption timeline during a crisis.

Check Your Understanding

Practice Question 1

An investor in a debt-oriented mutual fund faces a ’liquidity risk’ in which of the following scenarios?

Practice Question 2

Under SEBI regulations, in a systemic market crisis, mutual funds are authorized to take which of the following actions regarding redemptions?

This is a companion read for Section 11.8 — Process associated with Investment in Mutual Funds from PASS Investment Adviser (Level 1) by Akhilesh Gururani, available on Amazon Kindle.

Copyright © 2026 HABSG Consulting

  1. The liquidity ratio is often approximated by assessing the proportion of the portfolio invested in cash, cash equivalents, and highly liquid government securities. ↩︎