6.

OPEN-ENDED MUTUAL FUNDS ALONG:

a) Collateral – related risks: financing and credit

 Liquidity risk - Open-ended funds allow investors to redeem their units on

demand. This means the fund needs to maintain adequate liquidity to meet
redemptions. If a large number of investors redeem at the same time, the fund
may be forced to sell less liquid assets quickly at unfavourable prices. This
could lower the value of remaining units.
 Valuation risk - Open-ended funds need to value their assets on a daily basis to
determine fund prices. Some assets like real estate or private equity are
complex to value. Incorrect collateral valuation can lead to inaccurate fund
prices.
 Credit risk - Funds may accept collateral against loans given to borrowers. If the
borrower defaults, the fund would seize the collateral. However, collateral
value may have declined in the interim. This results in a loss for the fund.
 Concentration risk - Funds may have a high concentration of certain types of
collateral if they specialize in lending against those assets (e.g. real estate). This
lack of diversification amplifies risks associated with that collateral type.
 Operational risk - Handling collateral entails legal processes like registration of
charges, custody, enforcement of rights etc. Any lapses in carrying out such
processes can negatively impact a fund's ability to recover credit exposures
through liquidation of collateral.

b) Statistical related risks: volatility and correlation

Volatility;
Open-ended mutual funds can experience volatility in their net asset values
(NAVs) based on the performance of the securities in their portfolios.
Equity funds usually see higher NAV volatility than fixed income funds because
stock prices can swing more dramatically than bond prices. Sector funds
focusing on narrow segments tend to be more volatile too.
Volatility can be measured using metrics like standard deviation of historical
NAV returns or beta relative to a market benchmark. More volatile funds have
wider NAV swings and higher standard deviations/betas.
Correlation
Open-ended funds have varying degrees of correlation of returns with their
benchmark indexes, other funds, and asset classes.
Correlations range from -1 to +1. A higher positive correlation means returns
tend to move in the same direction as the comparison. Lower/negative
correlation means there is little relation or an inverse relation.
Evaluating correlations allows investors to gauge diversification benefits. Lower
correlated funds may smooth out portfolio volatility versus higher correlated
ones that amplify market swings.
c)Magnifying risk factors: leverage and non-linearity
Liquidity Risk: This pertains to the ease with which investors can buy or sell
shares of a mutual fund without significantly affecting its price. Funds with low
liquidity may experience wider bid-ask spreads and higher transaction costs
Drawdowns: These represent the peak-to-trough decline in the value of a
mutual fund's investment over a specific period. Understanding drawdowns
can help assess potential losses during market downturns.
Correlation: This measures the degree to which the returns of a mutual fund
move in relation to another asset or index. Low correlation implies
diversification benefits as the fund's returns are less affected by movements in
other assets.
Standard Deviation: This quantifies the dispersion of returns around the fund's
average return. A higher standard deviation indicates greater volatility, and vice
versa.
Sharpe Ratio: This assesses the risk-adjusted return of a mutual fund by
considering its return relative to its volatility. A higher Sharpe ratio suggests
better risk-adjusted performance.
Alpha: This measures the excess return of a mutual fund relative to its
benchmark, after adjusting for risk. A positive alpha indicates outperformance,
while a negative alpha suggests underperformance.
d)Frictional risk factors: liquidity and regulation
Liquidity
Open-ended mutual funds are required to redeem shares at net asset value
(NAV) upon investor request.
High liquidity can be beneficial for investors seeking easy access to their
money, but it can also lead to higher transaction costs and potential
performance drag.
Low liquidity can offer lower transaction costs and potentially higher returns,
but it can also make it difficult for investors to exit their positions quickly.
Regulation:
Open-ended mutual funds are subject to various regulations that aim to
protect investors and ensure fair market practices.
These regulations can impact various aspects of the funds, such as investment
restrictions, fees, and reporting requirements.
Increased regulation can provide greater investor protection but may also limit
the flexibility of fund managers and potentially reduce returns.
e) Fallout risks: model failure and crises
Model Failure Risks
● Open-ended funds rely on portfolio managers and quantitative models to
make investment decisions. If those models are flawed or make poor
assumptions, it can lead to making inaccurate market bets and choosing
investments that underperform.
● For example, a model may incorrectly assess risk or future cash flows for a
particular asset class. If acted upon, this can cause the fund to lose significant
value.
● Additionally, unanticipated market events can reveal flaws in models that
investors and managers were previously unaware of. The models essentially fail
to capture real world complexities.
● When models fail, open-ended funds can face sudden declines in net asset
value. If large enough, this can trigger widespread investor redemptions.
Crisis Fallout Risks
● In market downturns or crashes, the fund may rapidly decline in value due to
marked-to-market accounting.
 ● Investors may panic and rush to redeem shares in response, fearing further
declines. But the ongoing crisis makes liquidating holdings difficult for the fund
manager.
● This liquidity mismatch leads to "fire sales" of assets at discounted prices to
meet redemptions, resulting in the fund's value spiralling lower.
● The crisis fallout risks are especially high for open-ended funds holding
illiquid assets like high yield bonds, real estate, or private equity. But even stock
funds can face challenges in crisis situations

7a) CREDIT RISKS IN OPEN ENDED MUTUAL FUNDS

Counterparty risk - Funds invest in various debt instruments and also have
capital market exposure through equities and derivatives. Default by any
counterparty the fund has invested in or has open positions with can result in
losses.

Collateral risk - Funds may lend against collateral like shares, bonds or other
assets. Decline in the value of collateral between the time of issuance and
liquidation can expose the funds to potential loss.

Downgrade risk - A drop in credit rating of instruments held by the fund leads
to mark to market losses as valuation of bonds gets impacted adversely due to
the downgrade.

Credit concentration risk - If the fund has a large holding in a company or

sector whose credit profile worsens, the entire fund NAV can get affected
severely. High concentration intensifies the risk.

Settlement risk - While rarely a concern in developed markets, delayed

settlement or default in settlement for transactions can create liquidity issues
and losses.

Liquidity risk - If faced with large redemptions, funds may be forced to sell
instruments at distressed valuations, causing loss in value.

b). Mutual funds are not guaranteed or insured by any institution.

c). Who provides the credit guarantee on the annuity contract? Is it the insurance
carrier or a third party? What is their credit rating?
How does the guarantee account for market downturns? Is there a ratchet design
that locks in annual returns or lifetime highest value?

Is the crediting rate calculated based on a portion of index gains? Is there a cap,
participation rate or spread deducted?

How often is interest credited to the annuity account value - annually, high water
mark etc.?

Does the guarantee only promise returns of the underlying index or does it
guarantee the actual annual contract value itself?

If the contract is terminated early, what are the surrender charges? Do they
override any accumulated gains?

Are there any exclusions that allow the carrier to avoid paying the guarantee
under certain circumstances?

If the insurance carrier fails, is the annuity contract guarantee backed up by state
guarantee associations?

8) a) If the equities in an index have medium to high correlation, an open-ended

mutual fund investing in that index would not necessarily be a relatively safe
investment. The high correlation means the equities tend to move together, so if
the market goes down, many or most of the fund's holdings could decrease in
value simultaneously. This exposes the investor to significant market risk even
through the diversification of an index fund.

b.) In a down market, the insurance salesperson may want to ask the mutual
fund salesperson and financial advisor:

How have your funds' values declined during past market downturns? This
helps assess downward risk.
What strategies do you use to mitigate losses in bear markets? This
understands the risk management methods.
How long have your funds taken historically to recover losses after market
corrections? This evaluates ability to recoup losses.
c.) The mutual fund salesperson and financial advisor may want to ask the
insurance salesperson about the correlation between:
Labor force participation rate changes and equity market volatility. This gauges
if participation impacts stock market swings.
Participation rates across different age groups and their equity allocation
preferences. This assesses if participation shifts asset allocation.
Historical equity returns and periods of rising or falling participation over
decades. This analyzes if long-term equity performance relates to
participation trends.
10) i.) Large Capital Flows In and Out
With open-ended structures, mutual funds can experience large inflows and
outflows as investors buy and sell frequently.
Sudden spikes in redemptions can force funds to sell securities rapidly to pay
out investors, possibly at discounted prices.
Conversely, sudden spikes in investments can leave deposits uninvested until
suitable assets are purchased, dragging on returns.
These capital flow swings create liquidity risks and can impair a fund's ability to
efficiently manage its portfolio. They increase trading costs and compromise
strategic positioning.
ii. Lack of Intraday Trading
Mutual fund shares cannot be traded intraday like stocks and only transact
once per day after markets close at the daily NAV.
This means investors cannot respond to market news until the next day, forcing
them to accept stale pricing and lack of precision in trades.
Without continuous quotes, short-term mispricings between true NAV and
next-day NAV can occur that informed traders cannot arbitrage away.
iii. Limited Transparency
Unlike ETFs, mutual funds do not disclose their full holdings daily, updating
typically quarterly to semiannually.
This makes it harder for investors to independently assess and monitor on an
ongoing basis how much tracking error or risk funds have versus stated
benchmarks.
Investors must largely trust that fund managers are adhering to stated
strategies rather than verifying themselves