Liquid Mutual Funds Not To Adopt Money

SEBI has changed the rules for swimming and debt mutual funds. In a circular, they have mentioned the new rules:

• Liquid funds must get money in their bank accounts before 2 pm if they need to have the old day`s NAV. That is, if you put in money on Tuesday before 2 pm, you get Monday`s NAV.
• Money received after 2pm will get the NAV of the same day - that is, if you transfer money on Tuesday at 3pm, you`ll get Tuesday`s NAV.

• If money is "realized" later, you will get the past day`s NAV. For example, if I have a check on Tuesday at 1pm, they might get the money but at 4pm on Wednesday. In which case I will get Wednesday`s NAV.
• Funds can`t invest by borrowing money based on such inflows. I.E. If I leave them a cheque, they shouldn`t get on a short term borrowing (say intraday or for one day) to invest.

The reasons, in my opinion, are best mentioned in an example. (Note: This is a broader example - it doesn`t really apply - but I`m illustrating)

Let`s say Mr. Rich Guy (RG) gives a liquid fund a check on Friday, for 100 crores, at 11 am. The fund can`t have the money on Friday - the earlier it will get the money is on Monday. But, under the old rules, it had to give RG Thursday`s NAV!

This meant that the store would borrow 100 crores, for 3 days - Friday to Sunday - and put it in a smooth place (money markets). They would likewise want to adopt from the money market or from banks - obviously at higher interest rates.

Let`s say RG decides on Monday to "cash in" - that is, exit the investment. They make to break him the fall of 4 days (Thursday to Monday). But out of that, they have borrowed money for three days (Friday to Monday) at a somewhat higher interest rate!

Take the 100 crore example. For 4 days, at typical returns of 4%, a liquid fund might give 109,000 per day - or approximately 440,000 for 4 days. A 3 day borrowing of the same amount at, say, 5% involves paying out Rs. 410,000 as interest!

Now - let me say this - mutual funds didn`t allow this to happen, really. What they would do, is to ask that funds come on the same day, later that day. So there wasn`t a "weekend arbitrage" for liquid funds - that is good for illustration. But since they would accept applications in the morning, and borrow "intraday", this resulted in the funds paying out interest only for part of one day. But it still meant some interest was paid, and money borrowed.

The trouble is that this hurts overall liquid fund returns - because the interest hits the entire fund, not simply that investor`s account. If a few people make money in there for a longer term then they pay a portion of the stake on the borrowing.

The larger problem is transfer risk - earlier, the mind has been to give before 12 noon to a liquid fund (gets yesterday`s NAV), then do an immediate switch to a liquid plus fund before 3 pm (get`s today`s NAV for liquid, today`s NAV for liquid-plus) which earns some special interest. On 100 crores, this can be 1 lakh worth of interest! That hits investors in the liquid fund, and also if the liquid fund manager borrows to invest money_you can see where this is going.

(Read ET`s note on this)

The ordinance from SEBI doesn`t appropriate funds to adopt to deploy the money, so they take to make the money in their accounts before release and investing.

In addition, debt funds of all types need to insure they stimulate the money before an "applicable" cut-off time before they offer investors an NAV - for non liquid funds this isn`t usually a problem (they never do "previous day NAV", if I get my facts right).

This new rule fixes some of the problem. Though this "get NAV of former day" is downright stupid - I recognize we all think it`s not a big deal, but if you start pushing hundreds of thousands of crores into this, giving a previous-day-NAV will become impossible under any circumstances. But our history means the deep are exploited to being pampered, so it`s got to go step-by-step.

The new rule hurts brokers and rich investors who wanted to make vantage of the banking system to get double returns with the same money. It also hurts the liquid fund AMCs who were getting the flows; remember they have a portion of assets, regardless of the losses to the other investors. They`ll all surely blame the want of RTGS after 2 pm or about such random excuse, but they can`t be allowed to harm other investors regardless. I am sure RBI needs to appear at 24 hour real-time money transfer systems as a goal too, or at least expand to a larger window than current - and all such regulation will offer a base for such expansion.

Note: Equity funds have no such problems. You can pay by cheque today, and you`ll get today`s NAV (if you put before 3 pm). The conception is that equity settlements on the stock exchanges happens one day later anyway - if a fund buys stock, it inevitably to pay up the following day, by which meter the cheque has cleared. Sure, there is an abuse potential if cheques bounce, and that loophole also needs to be plugged.

Overall, this is reasonable regulation, and there`s enough money to be made in the flow environment (call money rates at 6.8%!). Here`s hoping more of those returns come to us.