The mutual fund industry is undergoing a transformation, adapting to various regulatory changes and is accordingly making amendments in the positioning of funds.
SEBI has recently introduced guidelines for valuation of debt securities in mutual funds. According to the circular, all money market and debt securities, including floating rate securities, with residual maturity of up to 91 days shall be valued at the weighted average price at which they are traded on the particular valuation day. When such securities are not traded on a particular valuation day, they shall be valued on amortization basis.
Also, the securities with a residual maturity of over 91 days would now be mark-to-market on a daily basis. So, these securities shall be valued either at the weighted average price at which it is traded on the particular valuation day or for those securities which are not traded on the valuation day, the benchmark yield or matrix of spread over risk-free benchmark yield shall be considered.
This regulation would impact the mutual fund industry as Liquid and Ultra Short Term fund category constitute around 53% of Industry’s Assets Under Management (AUM). The changes mean that all securities like Commercial Papers (CPs) and Certificate of Deposits (CDs) with residual maturity (the number of days remaining before maturity) of more than 91 days would be mark-to-market. The mark-to-market concept means that the value of an instrument is based on the current market price of that instrument or a similar instrument, or is based on another objectively assessed fair value. Moreover, the Non Convertible Debentures (NCDs) with maturity between 91 days and 182 days would similarly be marked-to-market.
This circular was supposed to be effective from 1 July 2010. However on 21 June 2010, SEBI made partial modification to the above circular by changing the effective date to 1 August 2010 from 1 July 2010 earlier. This action could have been taken in light of an expected short-term liquidity crunch anticipated in the next one month on account of payment of 3G telecom auction and advance tax outflow, which could further add to the volatility in prices of debt instruments affected by the circular in the interim.
Impact on Liquid funds
The Liquid fund segment would not be affected by this circular, the reason being that with effect from 1 May 2009, these funds were permitted to invest in instruments with residual maturity of up to 91 days only. Thus, the new clause would not affect the way these portfolios are being valued.
Impact on Ultra Short Term funds
The change would increase the volatility in Ultra Short Term funds. Ultra Short term funds do not have any restriction on the maturity of the papers they can invest in. However, given the positioning of these funds with average maturity levels slightly above the Liquid funds, the average maturity of these funds generally varies between 90– 180 days depending upon the fund management strategy.
The Ultra Short Term funds thus invest around 60-70% of the portfolio in CDs/CPs which generally have a residual maturity above 91 days but below one year. But these funds were so far being valued on accrual basis. Thus, a longer maturity within Ultra Short Term fund portfolio ensured higher returns than Liquid funds while less than one year maturity meant that the portfolio was not exposed to volatility caused by mark-to-market. But now with change in valuation methodology, it means going forward these funds could see some volatility in their NAV as compared to the present situation.
So as a preventive measure, many fund houses have introduced/increased exit load in their Ultra Short Term funds (ranging from 3 days to 15 days) and also reduced the maturity of the scheme. However, this regulation will majorly impact the corporate / institutional investors who contribute to the bulk of the assets in the Ultra Short Term funds. Refer to Table 1 for maturity profile of Ultra Short Term funds at the end of May 2010.
Table 1: Current Maturity profile of few schemes:
Impact on Individuals
Presently, funds which were not required by investors within a short time frame were parked in Ultra Short Term funds because of the tax arbitrage. Individuals pay only 14.16% (12% + 10% surcharge + 3% education cess) and Corporate pay 22.66% (20% + 10% surcharge + 3% education cess) as Dividend Distribution Tax (DDT) as compared to DDT of 28.325% (25% + 10% surcharge + 3% education cess) in liquid funds.
Meanwhile, the interest on savings accounts and other bank deposits are taxed at the marginal tax rate which could be at most 30% depending on the individual’s tax bracket. But with valuing security on daily basis, it is likely that the volatility of Ultra Short Term funds will increase, especially if the investment horizon is for a few days. So investors parking money for very short term are advised to keep the money in Liquid funds rather than Ultra Short Term funds.
Impact on Funds Houses
After the regulation, money which is parked for a very short term horizon in mutual funds may not be placed in Ultra Short Term funds, because of the perceived risk of increase in volatility especially during the times of low liquidity. Thus, fund houses could see some outflows from the ultra short-term category in the coming months. Also, in order to reduce volatility, the portfolio manager could lower the average maturity of the scheme, and as a result, they might have to settle for lower return.
Summary of Growth and Importance of Ultra Short term fund
Ultra short-term categories at current stage constitute around 45% of Industry AUM. The category has grown manifold over the years and from June 2007 to May 2010, the category has seen a gigantic rise of about 700% in its assets. The main reason for this has been the tax arbitrage benefit whereby Individuals and Corporate currently pay only 14.16% and 22.66% respectively as Dividend Distribution Tax on Ultra Short Term funds as compared to 28.325% on Liquid funds.
In the graph, we can see that the contribution of Ultra Short Terms funds (in overall assets of the mutual fund industry in India) has grown from a mere 12% in June 2007 to 45% in May 2010. At the same time, the contribution of liquid funds has reduced significantly from 22% in June 2007 to just 7% in May 2010. Thus, the tax arbitrage has helped in shift of assets from Liquid funds to Ultra Short Term funds.
Chart 1: Snapshot of Growth and Contribution of AUM of Ultra Short term category
Considering the perceived increase in the volatility of Ultra Short Term funds post 1 August 2010, we would recommend investors to consider investing in Ultra Short Term funds with a minimum horizon of 15 days and above. This is because some fund houses have introduced exit load in this fund category, plus an extremely short term investment horizon could bring in some volatility in the fund’s NAV and consequently affect the fund’s performance.
If an investor is looking to park money for less than 10 to 15 days, it would be advisable to invest in Liquid funds or bank savings account. However, investors who wish to invest money for the short-term can continue to look at Ultra Short Term funds as an investment vehicle, especially since the tax arbitrage still exists for these funds.