Change in Liquid Fund portfolio valuation norms
As an after effect of credit events in Sept. 2018, causing sudden spike in Money Market rates affecting the returns of liquid investors; SEBI revisited the valuation norms to better reflect market risks within the liquid fund category, SEBI announced that all the securities beyond 30 days maturity would be subject to daily mark-to-market (MTM) which was not the case earlier.
Liquid fund returns poised to come down
Earlier securities beyond 60 days were subject to Daily MTM, hence most liquid funds were immune to small movement in the yield. Most of the liquid fund returns were in line with their respective YTM. With the change in valuation norms, a significantly higher proportion of the portfolio will be revalued daily which may have an adverse impact on fund predictability and volatility.
One way to reduce the adverse impact may be to reduce the duration of the portfolio towards 30-day maturity. As the fund managers shift their portfolio to shorter-term papers to avoid mark to market risks of their portfolio, yields on liquid scheme could moderate.
Currently, the spread between 30 day and 60-day papers is 50 to 60bps. If the fund managers start reducing the duration of the fund in order to attain lower volatility and demonstrate higher predictability, investors may get relatively lower returns compared to present returns.
Arbitrage funds offer a relatively better solution
Investors looking for low-risk investment with better predictability along with transparency can invest in arbitrage funds. Arbitrage funds invest in Cash Future Arbitrage and fixed income instruments.
Benefits of Arbitrage funds
- Predictability & Transparency
Up to 90% of the fund is invested in Cash Future Arbitrage and fixed deposits which have no MTM impact as in arbitrage trades, the yields are captured on expiry day demonstrating higher predictability.
- Tax Efficiency
Arbitrage funds are equity oriented funds and hence, short term capital gain is taxed @ 15% as compared to 34% in liquid funds.