Discover what happens during mutual fund panic redemptions, how it differs from bank collapses, and what investors should do to protect their money.
In recent times, Indian investors have become increasingly comfortable with mutual funds as a go-to investment option for long-term wealth creation. The “Mutual Funds Sahi Hai” campaign helped break old beliefs, drawing lakhs of new investors into the world of professionally managed portfolios.
But one question continues to haunt investors—what happens if everyone suddenly pulls out their money from a mutual fund?
We saw glimpses of this fear during the Franklin Templeton debt fund crisis in 2020. When investors panic, and redemption requests pour in rapidly, how exactly does a mutual fund handle the pressure? More importantly, can a mutual fund collapse like a bank does?
Let’s unpack this in simple terms, backed by real events, and understand the potential risks—and safety mechanisms—in place.
How Mutual Funds Work: A Quick Recap
When you invest in a mutual fund, you’re essentially buying units of a pooled investment. The fund manager then invests this money across a basket of securities—stocks, bonds, or a mix depending on the scheme.
Unlike banks, mutual funds don’t promise capital protection or fixed returns. Your money is subject to market risks, and the value of your investment is determined by the Net Asset Value (NAV), which fluctuates daily based on underlying asset prices.
What Is a Panic Redemption in Mutual Funds?
Panic redemption occurs when a large number of investors decide to exit a mutual fund scheme simultaneously, often triggered by:
- Negative news or rumors about the fund or AMC
- Market crashes
- Credit rating downgrades/defaults in portfolio assets
- Poor scheme performance
- Global economic shocks or regulatory changes
This is similar to a bank run, where depositors rush to withdraw money due to fear of insolvency. But in mutual funds, the structure and implications are different.
What Happens When a Mutual Fund Faces Massive Redemptions?
1. The Fund Starts Selling Assets
To meet redemption requests, the fund house begins selling securities from its portfolio. In equity funds, that means offloading stocks. In debt funds, it means selling bonds.
However, unlike stocks, debt securities—especially corporate bonds—may not always have ready buyers. This can force fund managers to sell the more liquid, high-quality securities first, leaving the portfolio with lower-rated or less-liquid assets.
2. NAV Erosion
As fund managers offload securities—sometimes below fair value—NAVs start falling. This impacts all unit holders, even those who don’t redeem.
In debt funds, selling illiquid bonds under pressure can distort fair pricing, affecting NAV accuracy and stability.
3. Portfolio Quality Deteriorates
As better quality assets are sold to meet withdrawals, the remaining portfolio may consist of riskier or longer-maturity securities. This leads to a worsening risk profile—a red flag for new or remaining investors.
4. Spiral Effect: More Panic, More Redemptions
As news spreads and NAVs fall, more investors panic, leading to a snowball effect. The cycle of redemptions and fire-sales continues unless the AMC intervenes or markets stabilize.
5. Fund Suspension or Winding-Up (Extreme Cases)
If redemptions become unmanageable, the AMC may take one of the following actions (subject to SEBI approval):
- Temporarily limit or pause redemptions
- Put the scheme under segregated portfolio treatment (side-pocketing)
- Wind up the scheme to protect existing investors
This is what happened in 2020 when Franklin Templeton shut down six of its debt schemes, citing illiquidity and severe redemption pressure.
Can a Mutual Fund Collapse Like a Bank?
Short Answer: No—but the impact on investors can still be serious.
How Mutual Funds Are Different:
| Aspect | Banks | Mutual Funds |
| Customer Type | Depositor (Loan to Bank) | Investor (Market-linked) |
| Capital Guarantee | Yes (up to ?5 lakh by DICGC) | No capital guarantee |
| Regulatory Body | RBI | SEBI |
| Failure Consequence | Insolvency, moratorium, deposit insurance | NAV fall, redemption delay, fund winding |
| Bailout Possibility | Yes (Govt. or RBI may intervene) | No bailout—investor bears market risk |
While a mutual fund cannot technically go bankrupt like a bank, your money is still at risk if:
- The scheme is poorly managed
- The fund holds risky or illiquid assets
- Panic leads to redemption pressure and forced asset sales
The Franklin Templeton Example – What Went Wrong?
In April 2020, Franklin Templeton India shocked investors by winding up six debt mutual fund schemes with over Rs.25,000 crore in AUM. The reasons cited:
- Exposure to lower-rated, illiquid corporate bonds
- Severe redemption pressure post COVID-19 lockdown
- Inability to sell underlying bonds in the secondary market
While investors ultimately received most of their money over the next year or two, the delay and uncertainty created panic in the industry. It became a textbook example of what can happen when liquidity dries up in debt funds.
How Safe Are Mutual Funds Now?
Post the Franklin episode, SEBI tightened regulations for debt mutual funds:
- Mandatory holding of liquid assets in short-term debt schemes
- Greater transparency in credit risk and exposure disclosures
- Limits on exposure to unrated or low-rated papers
- Daily portfolio disclosures for debt schemes
Additionally, many AMCs have shifted toward higher-quality papers, and target maturity funds (TMFs) have emerged as a safer, transparent alternative for debt investors.
How Can You Protect Yourself?
Here are a few practical tips to avoid getting caught in a fund under redemption stress:
1. Understand the Fund’s Portfolio
Check the fund’s holdings—look out for excessive exposure to lower-rated bonds, concentrated holdings, or private placements.
2. Prefer Funds with High Liquidity
In debt funds, schemes with higher exposure to G-Secs, PSU bonds, or AAA-rated instruments are more liquid and safer during stress.
3. Match Your Investment Horizon
Don’t park short-term money in long-duration or credit risk funds. Stick to liquid funds, money market funds, or even FDs for goals within 1–2 years.
4. Diversify Across AMCs and Schemes
Avoid overexposing your portfolio to a single fund house or category. Even among debt funds, maintain category diversification—corporate bond funds, banking & PSU funds, short-duration, etc.
5. Stay Calm in a Crisis
Panic selling often results in locked-in losses. Unless absolutely necessary, avoid withdrawing during market stress—especially if your goals are long-term.
Final Thoughts
Mutual funds are powerful investment tools—but they aren’t foolproof. Unlike banks, they don’t offer capital guarantees, and during periods of redemption pressure, investors can face significant NAV erosion or delays in accessing their money.
That said, the system is better regulated than ever before, and investors who stay informed, diversify smartly, and match investments with goals can continue to benefit from mutual funds without falling into panic traps.
The key is to invest with knowledge, not fear.