Investors in liquid and liquid-plus (ultra-short term) mutual funds may soon find it unattractive to park their surplus fund in these schemes. Capital markets regulator, Securities and Exchange Board of India (Sebi), is planning to tighten the valuation norms. That should make these more volatile.

To begin with, the regulator is planning to impose mark-to-market (MTM) requirements for instruments with a residual maturity period of 60 days and more. Sebi, eventually, wants all instruments irrespective of their tenure and type to be quoted on market rates and the net asset value (NAV) calculated accordingly, say people familiar with the developments. The move was earlier discussed by the mutual fund advisory committee.

This move is likely to make liquid and liquid-plus funds more volatile because of the fluctuations in underlying assets, says the fixed income head of a private sector fund house. Liquid and liquid-plus funds allow quick entry and exit to investors. They, typically, invest in money market instruments such as certificates of deposit, commercial paper and treasury bills. These funds are especially used by companies, banks and high net-worth individuals to park their surplus funds in the short term. Retail investors also invest in these schemes and move money to equity schemes through systematic withdrawal plans.

“We have already got feelers from Sebi. We are expecting an official communication soon. The market regulator feels amortising does not adequately reflect the market value and could lead to systemic risks," says the chief operations officer of a private sector fund house, adding that initially the MTM valuation for bonds with a tenure of over 60 days will be applied.

Arjun Parthasarathy, a fixed income expert and founder of investorsareidiots.com, says, “MTM reduces systemic risk. Without it, funds are giving an implicit guarantee to the investors of a certain rate of return. But, unlike banks, they do not have the capital backing."

Investors use liquid-plus funds as a cash management tool. At present, they are earning 8-8.5 per cent annualised returns. Due to the amortisation method used now, they do not experience volatility in the portfolio up to 90 days.

RBI and Sebi have repeatedly expressed concerns about banks and corporates round-tripping investments using liquid funds. Fund houses have lost significant money in liquid funds since RBI capped banks’ investments in liquid funds at 10 per cent of their net worth in May last year.

According to the mutual fund industry body, Amfi, assets under management of liquid and money market schemes nearly halved to Rs 1.2 lakh crore or 20 per cent of the industry in December 2011. At the end of April 2011, liquid funds managed Rs 2.2 lakh crore, accounting for 28 per cent of the industry.

Sebi’s discomfort with the valuation of debt instruments has been there since 2008. After the Lehman Brothers collapse, a number of fund houses faced severe redemption pressure from companies. For instance, Lotus Mutual Fund sold its business to Religare in November 2008 after it lost almost Rs 2,500 crore in its liquid and liquid-plus schemes in a single month. In July 2010, Sebi has introduced similar MTM guidelines for more than 91-day papers. As a result of this rule, many fund houses booked heavy losses in FY11. For instruments of shorter tenure, fund houses follow the amortisation method, where the returns on the instrument are pro-rated over the tenure of the instrument.