How Mutual Funds Manage Market Crashes

A market crash can cause sharp declines across stocks, bonds and other financial assets. Mutual funds cannot prevent these declines or guarantee that investors will avoid losses. Instead, fund managers and asset management companies (AMCs) use portfolio construction, diversification, liquidity management, valuation rules and risk-management frameworks to manage the impact of stressed markets.

The way a mutual fund responds depends on its category. An equity fund, debt fund and hybrid fund face different risks during a market downturn. Investors therefore need to look at the scheme's investment objective, portfolio and risk level rather than assuming that all mutual funds respond to a crash in the same way.

As of May 31, 2026, India's mutual fund industry had ₹81.58 lakh crore in assets under management (AUM), across 1,946 schemes. Growth/equity-oriented schemes accounted for approximately ₹36.1 lakh crore of the industry's assets, according to AMFI data.

What happens to mutual funds during a market crash?

The Net Asset Value (NAV) of a mutual fund is the value of the securities and other assets held by the scheme, with less liabilities and expenses. When the market value of the securities in an equity fund drops, the fund’s NAV usually drops, too.

For example let us say a scheme has equity securities of ₹ 100 crore and other net assets of ₹ 5 crore. For example, if the value of its equity holdings falls by 20%, then normally its net assets would fall by about 20 crore, all else being equal, and its NAV per unit would fall by a similar amount.

This does not mean that the fund itself is no longer operating. The management of the portfolio continues to be carried out in accordance with the scheme’s investment objective and regulations.

The mutual fund framework prescribed by SEBI mandates adherence to valuation principles and calculation of NAV based on the scheme’s net assets and outstanding units. The present regulatory framework is contained in the SEBI (Mutual Funds) Regulations, 2026 and the corresponding Master Circular for Mutual Funds.

How mutual funds manage market crashes

Mutual funds manage market crashes primarily by controlling portfolio-level risks rather than trying to prevent losses. Depending on the scheme, this can involve diversification, asset allocation, rebalancing, liquidity management, credit-risk controls and appropriate valuation practices.

Diversification across securities

Diversification reduces the risk of a particular company and concentration risk. Equity funds typically hold a diversified basket of securities but the SEBI regulatory regime has caps on exposure to certain issuers and asset classes. But diversification doesn’t remove market risk: if the market falls widely, many holdings can fall at the same time.

Allocation of assets in hybrid funds

Hybrid funds invest in asset classes such as equity and debt based on the stated strategy of the scheme. Exposure to other asset classes may reduce or change the exposure of the portfolio to equities during a decline in the equity market. This will depend on the actual allocation and investment mandate of the scheme. So investors should check the scheme’s asset allocation and riskometer and should not assume that a hybrid fund is immune to market falls.

Portfolio rebalancing

Market movements can push a portfolio away from its intended asset allocation. Where the scheme's mandate permits, the fund manager can rebalance holdings to bring the portfolio closer to its stated strategy. Rebalancing manages portfolio allocation; it does not guarantee returns or prevent losses.

Liquidity management

Sharp market declines can be accompanied by higher redemption requests, making liquidity management important, particularly for open-ended debt schemes. SEBI requires all open-ended debt schemes, except overnight schemes, to conduct internal stress tests at least monthly, and more frequently when market conditions require it. These tests assess risks including interest-rate, credit, liquidity and redemption risks.

Monitoring credit risk in debt funds

Debt funds also monitor the credit quality and liquidity of their holdings. In specified credit-event situations, SEBI permits the creation of a segregated portfolio, or side pocket, for affected debt and money-market securities. The mechanism separates affected securities from the main portfolio but does not protect investors from losses or guarantee recovery of the investment.

Using derivatives where permitted

Some schemes may use derivatives for hedging, rebalancing as per SEBI requirements and the mandate of the scheme. Derivatives can be used to hedge some risks, but they are no protection against a market decline in a mutual fund.

Portfolio value under stressed markets

Valuation accuracy becomes especially important during volatile markets. In terms of the present SEBI framework, investment in mutual funds should be valued on the basis of the principles of fair valuation and with values that reflect the realisable value of the securities/ assets on the relevant date. The valuation shall be done in a true and fair manner and in good faith in accordance with the valuation policies approved by the AMC and guidelines laid down by SEBI.

Do mutual funds stop redemptions during a crash?

Not ordinarily.

Open-ended mutual funds are designed to allow investors to buy and sell units according to the scheme’s terms. However, the SEBI framework provides for specific circumstances under which redemption restrictions can be imposed, such as a systemic crisis or an event which severely constricts market liquidity or the efficient functioning of markets. The restrictions are subject to regulatory conditions and are not a general response to ordinary market volatility.

This distinction is important because a big decline in the stock market does not mean that investors are losing access to their mutual fund units.

How different mutual fund categories behave in a crash

The table is a general explanation, not a prediction of how a particular scheme will perform. Actual behaviour depends on the securities held, portfolio positioning and market conditions.

What investors should check during a market crash

A market decline can make short-term performance appear more important than it is. Investors should instead examine whether the scheme continues to match its intended purpose.

Key points to review include:

• Investment objective: Check whether the scheme's strategy still matches the intended investment purpose.
• Portfolio allocation: Review the latest disclosed portfolio and asset allocation.
• Riskometer: SEBI requires mutual fund schemes to display a riskometer using six risk levels, from Low Risk to Very High Risk.
• Credit quality: This is particularly relevant for debt funds.
• Liquidity: Consider whether the underlying securities can be bought or sold efficiently during stressed conditions.
• Time horizon: A short-term market decline and a permanent impairment of capital are not necessarily the same event.
• Scheme-specific disclosures: Read the Scheme Information Document (SID), Key Information Memorandum (KIM) and periodic portfolio disclosures before drawing conclusions about a scheme.

Investors should also avoid assuming that a mutual fund manager can predict the exact bottom of a market crash. Portfolio management generally involves managing risk within the scheme's mandate rather than accurately timing every market movement.

How 5paisa can fit into mutual fund investing

5Paisa provides access to mutual fund schemes through its investment platform, with information on schemes, fund categories and investment options. Its mutual fund platform also provides tools for comparing schemes and calculating potential investment outcomes.

For investors using a platform such as 5paisa, the important consideration remains the same. Understand the scheme, assess the risk, review the relevant documents and make investment decisions based on your own financial circumstances and objectives. A platform provides access to Mutual Funds. It does not eliminate the market risks involved.