Last week came the news that the mutual fund industry has had the biggest monthly decline ever in terms of the amount of money it is managing. In percentage terms, the 15.8 per cent drop of Rs 1.3 lakh crore from Rs 8.1 lakh crore to Rs 6.8 lakh crore was lower than the 18.4 per cent decline at the height of the global financial meltdown in October 2008. On the face of it, this looks like disastrous news and seems to segue into the dire crisis faced by funds as a result of the abolition of entry loads. However, a more knowledgeable analysis of this missing Rs 1.3 lakh crore paints a different picture. Broadly, the fund industry is engaged in three fundamentally different kinds of business. These are short-term debt, long-term debt and equity. When I break up the decline in assets managed into these three, I get a far more informative picture. Assets in short-term debt funds declined by Rs 1.22 lakh crore, in long-term debt funds by Rs 9,200 crore and in equity they actually increased by Rs 4,300 crore. What is interesting is that debt funds never had any entry load so the abolition of entry so the question of its being affected by its abolition does not arise.
As you can see, the prime reason for the decline in assets managed is the investors’ sudden flight from short-term debt funds. The reason for this lies almost entirely in an impending change in the basic character of these funds, a change that has been necessitated by new rules that SEBI has made regarding the valuation of assets held by the shorter-term funds. These changes were initially planned for July 1. They’ve now been postponed by a month but their affect is clear.
Short-term funds are primarily used by corporates to park cash that is unused for short periods of times, often no more than a week or so. These funds suit the purpose well because of their highly predictable returns. However, under new valuation rules that SEBI has implemented, these funds are going to be a lot less predictable.
From August 1, their daily valuation is going to be done on the basis of the market price of their investments, rather than a straight-line value calculated from their coupon rate, as has been the practice so far. The straight line value assumes that for bonds with only a small period of time left to go for their maturity, the market price is not material. Investors can invest in them even for the shortest periods and know precisely how much can they expect the NAV to be each day in the future.
Under the new rules, funds will have to use the market price for valuing bonds of less than 91 days maturity. Practically speaking, this means that daily NAVs of these funds are no longer so precisely predictable. The shorter the period, the less the predictability. Moreover, over very short periods the NAV could even move downwards. For many CFOs, this would be completely unacceptable. There’s no way they would park cash in an asset where there would be any chance, no matter how small, of making a loss.
From an industry perspective, the question is how this will affect business. One should clearly recognize one thing and that is that this change is a positive one and actually improves the basic characteristics of these products. Going forward, I expect the impact on these funds will be less than is being feared right now. There will be a phase when a lot of CFOs will run shy but in a couple of months, they’ll figure out that the volatility can be mostly understood and managed.