For most investors, the portfolio disclosure sheet of a mutual fund is the ultimate comfort document. It lists the securities owned, their valuations, and their weights in the scheme. Investors assume that what they see is an accurate snapshot of reality—clean, transparent, and reliable.
But here’s the shocking truth: mutual funds can (and often do) hide illiquid assets inside these “valued” portfolios, dressing them up with creative accounting and opaque valuation methods. While regulators mandate periodic disclosure, the numbers can still mask the fact that part of your money is stuck in securities that cannot be sold at anywhere near the reported price.
What Are Illiquid Assets in Mutual Funds?
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Unlisted Debt Securities: Bonds or debentures that don’t trade regularly in secondary markets.
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Unlisted Equity: Stakes in startups or pre-IPO companies without reliable market pricing.
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Thinly-Traded Bonds: Corporate debt that changes hands so rarely that valuations are “theoretical.”
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Structured Products: Exotic instruments with no transparent benchmarks.
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Distressed Assets: Securities from companies facing defaults, bankruptcies, or rating downgrades.
For retail investors, these are invisible risks—they sit quietly in portfolios, “valued” as if they were liquid.
The Tricks Funds Use to Hide Illiquidity
1. Valuation by Models, Not Markets
When there are no real trades, fund houses rely on pricing models. These often use optimistic assumptions that inflate values, painting an illusion of stability.
2. Last Traded Price Fallacy
Funds may report securities at their last traded price—even if the trade was months old and volumes negligible.
3. Pooling Illiquid Holdings
Illiquid securities are buried under broad labels like “others” in portfolio disclosures, making them harder for retail investors to identify.
4. Side Pockets (with a Twist)
While SEBI allows side pockets for distressed securities, some funds delay moving bad assets into them, continuing to show inflated NAVs.
5. Cross-Group Transactions
In some cases, affiliated entities “trade” illiquid assets at artificial prices, allowing the AMC to mark them at inflated values.
Case Studies
1. Franklin Templeton Debt Fund Shutdown (India, 2020)
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Issue: Six schemes worth ₹26,000 crore froze redemptions.
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Cause: Portfolios loaded with illiquid corporate debt, especially from NBFCs and smaller issuers.
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Valuation Trick: Before the freeze, NAVs were maintained using valuation models that did not reflect real liquidity. Investors were shocked to discover the true fragility only when gates came down.
2. UTI Crisis (2001)
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Issue: The flagship US-64 scheme invested in numerous illiquid and politically sensitive assets.
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Valuation Trick: NAVs were managed with opaque methods until the shortfall became undeniable, forcing a government bailout.
3. Global Example – U.S. Mortgage-Backed Securities (2008)
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Issue: Many bond funds held mortgage-backed securities that had virtually no buyers in crisis.
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Valuation Trick: Funds reported them at “model values” long after markets had priced them near worthless.
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Impact: Investors thought portfolios were healthy until reality caught up.
Why AMCs Do This
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NAV Stability Illusion
Smooth NAVs attract investors. Reporting real volatility from illiquid assets would scare them off. -
Performance Rankings
Inflated valuations keep funds high in “best-performing” lists, driving inflows. -
Fee Preservation
Fees are earned on AUM. If NAVs collapse due to honest valuation, AMCs lose revenue. -
Reputation Management
No AMC wants headlines saying “Fund Lost 20% Due to Illiquid Bets.”
Why SEBI Struggles
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Reliance on Pricing Agencies
SEBI mandates third-party valuation, but agencies also use models when trades don’t exist. -
Time Lags
Monthly disclosures mean investors learn about exposures too late. -
Loopholes in Categorization
Debt categories like “credit risk” allow significant illiquid exposure without explicit red flags to retail investors. -
Political Pressure
Major fund houses tied to banks or conglomerates exert influence to avoid strict penalties.
Impact on Investors
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Sudden NAV Collapses
When a downgrade or default finally forces revaluation, NAVs crash overnight. -
Frozen Redemptions
As seen in Franklin’s case, investors may be locked out of their money for years. -
Asymmetric Information
Insiders and institutional players sense liquidity stress earlier, while retail investors remain blind. -
Loss of Trust
Retail investors lose faith in mutual funds as “safe” options for wealth creation.
Ethical Reflection
Hiding illiquid assets behind inflated “valuations” is technically legal but ethically dubious. Mutual funds are fiduciaries—they are supposed to protect investors, not mislead them with model-driven illusions.
By prioritizing reputation and fee income over honest disclosure, AMCs weaponize valuation against the very investors they serve.
How Investors Can Protect Themselves
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Scrutinize Portfolio Disclosures
Look for unlisted securities or “others” categories. -
Check Risk Category Labels
Funds with “credit risk” or unusually high yields are likely hiding illiquid exposures. -
Prefer Transparency
Choose AMCs that clearly explain valuation methodology. -
Diversify
Don’t put all fixed-income exposure in one AMC or one risky debt category. -
Track Rating Actions
Monitor credit rating downgrades of fund holdings. They often precede revaluations.
Conclusion
Illiquid assets are the silent saboteurs of mutual fund portfolios. Dressed up in “valued” disclosures, they appear safe and steady—until crisis strikes. From Franklin’s freeze in 2020 to UTI’s opacity in 2001 and global mortgage-backed disasters in 2008, the story is the same: valuations mask reality until it’s too late.
For regulators, the challenge is to demand real-time, market-based pricing and plain-English disclosure. For AMCs, the duty is to stop hiding behind models and respect fiduciary obligations. And for investors, the lesson is vigilance: if a debt fund’s returns look too smooth, it may be because the rough truth has been hidden from view.
Because in the world of mutual funds, the most dangerous assets are often the ones that look calmest on paper.
