The overvaluation game in mutual fund portfolios

Mutual funds are often seen as the safest route for retail investors to participate in financial markets. They promise diversification, professional management, and transparency. Investors place their hard-earned savings into these schemes, trusting that their money is being valued fairly.

But beneath this promise lies a dangerous reality: the overvaluation game. Mutual funds sometimes assign values to portfolio assets that are far above their true worth, inflating Net Asset Values (NAVs), masking risks, and misleading investors. Whether done deliberately or through “market convention,” overvaluation distorts the integrity of fund performance reports and erodes investor trust.

This article dives into how the overvaluation game is played, historic cases of inflated valuations, its consequences, and what investors should look out for.

What Is Overvaluation in Mutual Funds?

In simple terms, overvaluation occurs when a mutual fund assigns an asset a price higher than its fair or realizable market value.

This can happen in several ways:

• Inflating the price of illiquid securities that don’t trade frequently.

• Using optimistic models instead of actual market prices.

• Delaying or avoiding markdowns when assets are downgraded or in distress.

• Creating side pockets but valuing them higher than realistic recovery levels.

The result? Investors see a healthier NAV than reality, encouraging them to invest more or stay invested, while risks pile up under the surface.

Why Do Fund Houses Overvalue Assets?

1. Attracting Investors
   Higher NAVs and stable performance lure new investors into the scheme.

2. Hiding Bad Bets
   Managers delay recognizing losses to avoid reputational damage.

3. Competing in Performance Rankings
   In an industry where relative performance drives inflows, showing higher returns—even if artificially inflated—gives funds a marketing edge.

4. Fee Maximization
   Since fund management fees are linked to assets under management (AUM), inflated NAVs increase AUM and, therefore, fees.

5. Regulatory Gaps
   Valuation rules often leave room for interpretation, especially for debt securities and private placements.

How the Overvaluation Game Is Played

1. Illiquid Bonds and Private Placements

Debt funds often invest in corporate bonds that do not trade actively. Instead of marking them to realistic market prices, funds may use outdated or theoretical valuations.

2. Delay in Marking Down Defaults

When a borrower misses payments or gets downgraded, funds sometimes delay marking the bond’s value lower, cushioning NAVs temporarily.

3. Circular Pricing Support

Funds within the same group or linked brokerages may trade thinly traded securities among themselves to “manufacture” a higher market price.

4. Optimistic Recovery Estimates in Side Pockets

When bad assets are moved to side pockets, funds may still value them generously, creating false hope of recovery.

5. Window Dressing Before Disclosures

Just before quarterly portfolio disclosures, funds may push up valuations with selective trades, only to let them slip afterward.

Historic Examples

1. UTI US-64 Crisis (2001)

India’s largest mutual fund scheme, US-64, overvalued many of its equity and debt holdings while continuing to promise assured returns. When the reality emerged, millions of investors faced steep losses, requiring a government bailout.

2. IL&FS Defaults (2018)

Several debt funds held IL&FS bonds but delayed markdowns even after the company defaulted. For weeks, NAVs remained artificially high, until SEBI forced recognition of losses.

3. Franklin Templeton Debt Fund Collapse (2020)

Franklin’s debt funds were packed with risky, illiquid bonds valued optimistically. When redemption pressure hit, funds were shut down, trapping investors. Subsequent valuations showed just how inflated NAVs had been.

4. Global Example – 2008 Financial Crisis

Before the crisis, US mutual funds holding mortgage-backed securities often overvalued them, relying on ratings and models rather than true market conditions. Once defaults spiked, the overvaluation was exposed.

Why SEBI’s Rules Fall Short

• Model vs. Market Prices
  For illiquid securities, funds are allowed to rely on model-based valuations. These models can be gamed with optimistic assumptions.

• Delayed Recognition of Stress
  Regulations permit a lag in marking down stressed assets, giving room for “hope accounting.”

• Disclosure Gaps
  Investors see NAVs daily but don’t see the assumptions behind valuations.

• Weak Enforcement
  Even when overvaluation is exposed, penalties are often small compared to the investor losses.

Consequences of Overvaluation

1. Retail Investor Losses
   Investors buy units at inflated NAVs, only to suffer when corrections occur.

2. Redemption Panic
   Once markdowns are forced, panic redemptions accelerate, causing liquidity crises.

3. Loss of Trust
   Every scandal erodes faith in mutual funds as a vehicle for the common investor.

4. Systemic Risk
   Overvaluation across multiple funds creates hidden fragility in the financial system, as seen in India’s NBFC crisis.

The Ethical Question

Overvaluation is not always outright fraud—it is often hidden behind “industry practices” and “valuation models.” But ethically, it misleads investors by presenting a rosier picture than reality.

Mutual funds are supposed to act as custodians of investor wealth, not as magicians who hide risks behind inflated numbers. The thin line between “optimism” and “deception” is frequently crossed in the pursuit of fees and reputation.

How Investors Can Protect Themselves

1. Look Beyond Returns
   Don’t just focus on NAV growth. Examine portfolio holdings, credit ratings, and sector exposures.

2. Beware of High Yields in Debt Funds
   If a debt fund promises significantly higher yields than peers, it may be taking excessive risks masked by inflated valuations.

3. Track Side Pockets
   Study how funds value assets in side pockets and be cautious of overly optimistic recovery assumptions.

4. Diversify
   Spread investments across fund houses and categories to minimize exposure to hidden risks.

5. Follow Independent Analysts
   Independent financial researchers often flag risky concentration and overvaluation before regulators act.

The Future of Valuations

• AI-Driven Oversight: Regulators may soon deploy AI tools to flag suspiciously high valuations in illiquid securities.

• Stricter Valuation Norms: Mandatory independent valuation agencies could reduce discretion for fund houses.

• Real-Time Transparency: Blockchain and digital disclosures could allow investors to see valuation methodologies openly.

• Global Lessons: Adopting best practices from stricter regimes like the US SEC may tighten loopholes.

Conclusion

The overvaluation game in mutual fund portfolios is more than a technical accounting issue—it is a silent threat to investor wealth and trust. From UTI’s collapse to Franklin Templeton’s shutdown, history shows that when fund houses play loose with valuations, it is retail investors who pay the price.

For regulators like SEBI, the challenge is to close loopholes that allow inflated valuations to persist. For fund houses, the duty is moral as much as financial: transparency must take precedence over cosmetic performance.

For investors, the takeaway is vigilance. Because in mutual funds, numbers on paper may look safe, but behind them may lurk a dangerous game of overvaluation.

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