Human wants never end. We always aspire for more than what we have. Similar applies to investments and returns. If investors find new suitable opportunities in the market, they seek to acquire them. However, in this process, liquidity can become a hurdle.
We usually observe this situation prominently in stock market trading. The markets fluctuate, and based on investor’s aspirations, one may find different investment opportunities. However, if they do not have ample funds for trading, they may miss the chance.
Markets provide a facility to overcome this hurdle. It is called pledging. It helps one gain added margins over existing funds to trade in the market in exchange for keeping security as collateral. Mutual funds can be one of the securities that can be pledged.
However, pledging mutual funds can have some pros and cons. Learn all about mutual fund pledging and its procedure.
Pledging mutual funds
In case there is a lack of funds to access investment opportunities in the stock market, one can pledge securities like shares and mutual funds to avail margin from the stockbroker. The pledging would work like a secured loan, where securities are locked like collateral. Investors can also use the facility of pledging in mutual funds.
The investor/trader can pledge their mutual fund units and execute the required trade in the market. When pledging mutual funds, investors should know the following terms:
- The amount received against the value of securities pledged is known as the margin.
- The % of the security value amount kept with the lender (broker here) is known as a haircut.
After the trade, investors would repay the obtained margin. If they fail to do so, their collateral can be sold by the broker.
An interesting read: What is a haircut in finance? Exploring its two key forms
Apart from this, investors can also pledge their mutual fund units for availing loans from banks and non-banking financial companies (NBFCs) with the help of their registrar and transfer agents (RTAs). However, the availability of this specific facility should be checked with the lending institution.
Due to such different aspects, understanding the mutual fund pledging becomes crucial. However, investors usually encounter the question of what is pledging in the stock market or to different entities and how it works.
Let’s learn it with an example.
- Pledging for investments:
Ms Maya wants to pledge 100 mutual fund units with a Net Asset Value (NAV) of ₹300 each. Therefore, her collateral value would be ₹30,000 (100*300).
Now, she received ₹25,500 as a margin from her broker for executing her trade. Here, the haircut will be 15% [(30,000-25,500)/30,000].
- Pledging for debt:
Mr Akshay wanted to avail a loan to purchase a car. ABC bank can provide him with the loan against some collateral security. He has a mutual fund investment with an Income Distribution cum Capital Withdrawal (IDCW) option that pays him dividend income.
He pledged these mutual funds for a car loan. In the following years, he repaid the loan. In the similar period, he also received dividends from the mutual funds as they are present in his portfolio.
How to pledge mutual funds?
Investors can follow the following steps:
- Step 1: Check the eligibility of your mutual fund scheme for the pledging process and other details with your fund house or RTAs.
- Step 2: If the units are to be pledged for margin trading in the stock market, one can check the broker’s application or website for this facility.
- Step 3: If the mutual fund units are to be pledged against the loan, a request has to be made to the lending entity with the required documents,such as an application form, income statement, collateral unit details, etc.
- Step 4: Post the mutual fund pledge approval, the fund house would lock the units in the investor’s portfolio.
- Step 5: After the usage of required funds, investors should repay the margin amount, and the broker or lending institution will close the pledge.
Check this out! What are mutual funds?
Pros and cons of pledging mutual funds
| Pros | Cons |
| Liquidity requirements are fulfilled to certain levels due to pledging. | Pledging a mutual fund is accompanied by the risk of losing the collateral if repayment is not done in time. |
| Investors can earn added returns if the executed trade is successful or collateral mutual fund earns potential income such as dividend. | If the fluctuating markets affect both, the pledged mutual funds and investment with margin money, the investors have to repay from the pocket. |
| It can be an alternative to mutual fund redemption. | The pledging process can be complex, and investors should understand it thoroughly before taking action. |
| Investors can get exposure to varied assets through the facility of mutual fund pledge. | The brokers may cost some fees for the procedure of pledging mutual funds. |
Remember this while pledging mutual funds!
Pledging can be a complicated process for newbies or investors lacking information. Therefore, one should consider some of the following points while pledging mutual funds:
- As per the amendment by the Securities Exchange Board of India (SEBI), the pledged securities will stay in the investor’s portfolio. If not found, one can inquire with the broker.
- The pledged mutual funds will be locked in the investor’s account, and no actions, like redemption, can be taken post the procedure.
- Investors should understand the mutual fund pledge process thoroughly and evaluate the risk levels to avoid any mishap with the investments.
- The details like cost of pledging, haircut % and other related norms may differ by brokers. Investors should clarify the same with their broker.
- Margin pledge conditions will ask for confirmation from investors at crucial stages in the pledging process.
Summary
Mutual fund pledge can be a feasible procedure for investors with insufficient funds for investments or one willing to avail loans. Usually, the traders use such options to procure margin for trading. However, individuals can also avail debt from banks and NBFCs by keeping mutual funds as a collateral.
However, mutual fund procedures are also accompanied by some risks of market fluctuations, default, loss of security, etc. Pledging is different from regular market procedures, so investors should follow some points while in the process.
Must read: Understanding pledging and unpledging of shares in the stock market
FAQs
- What is pledging in the stock market?
The process of pledging is similar to keeping collateral security for the loan. When a trader or investor finds a suitable investment opportunity, one may face the problem of insufficient funds. In such a scenario, investors can pledge the existing shares owned by them, and avail margin from their broker to use for trading. Further, they need to repay this amount at a future decided date, or the pledged shares will be sold by the broker.
- Is pledging allowed in mutual funds?
Yes, pledging is allowed in mutual funds. One can pledge their mutual fund units to avail margin for trading/investment or loan for specific purpose. Pledging is a temporary process and at the end, unitholders have to repay the procured amount to the lending entity or broker.
- What is a haircut in pledging?
When an investor pledges their securities, they will not receive a full amount against the collateral. The margin they receive will be lower than the market value of their security. The % of the difference between these values and the total security value is known as a haircut. For example, if a margin of ₹10,800 is received against the security of ₹12000, the haircut % will be 10% [((12,000-10,800)/12,000)*100].
- What are the disadvantages of pledging a mutual fund?
Pledging can be a beneficial alternative compared to the sale or redemption of security for funds. However, it can be risky during the period of market volatility. One may have to pay from the pocket or lose their mutual fund units. Moreover, investors have to pay fees according to lender’s norms for pledging their mutual fund units.
- Why do investors pledge mutual funds?
Mutual fund pledging can help investors earn potential returns from their collateral units (as ownership stays with the investors) and from the new investment. Moreover, this temporary process can help investors procure the required funds without selling their mutual fund units.
