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Fixed Income

Liquid Mutual Funds Not To Borrow Money


SEBI has changed the rules for liquid 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 want to give the previous 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 preceding day’s NAV. For example, if I give a cheque on Tuesday at 1pm, they might get the money only 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 give them a cheque, they shouldn’t take 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 cheque on Friday, for 100 crores, at 11 am. The fund can’t receive the money on Friday – the earliest 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 fund would borrow 100 crores, for three days – Friday to Sunday – and invest it in a liquid place (money markets). They would also need to borrow 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 have to give him the return of four days (Thursday to Monday). But out of that, they have borrowed money for three days (Friday to Monday) at a slightly higher interest rate!

Take the 100 crore example. For four days, at typical returns of 4%, a liquid fund might give 109,000 per day – or about 440,000 for four days. A three 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 demand that funds come on the same day, later that day. So there wasn’t a “weekend arbitrage” for liquid funds – that is just for illustration. But since they would accept applications in the morning, and borrow “intraday”, this resulted in the funds paying out interest just for part of one day. But it still meant some interest was paid, and money borrowed.

The problem is that this  hurts overall liquid fund returns – because the interest hits the entire fund, not just that investor’s account. If a few people have money in there for a longer term then they pay a part of the interest on the borrowing.

The bigger problem is transfer risk – earlier, the idea has been to apply 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 extra 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 regulation from SEBI doesn’t allow funds to borrow to deploy the money, so they have to have the money in their accounts before going and investing.

In addition, debt funds of all types need to ensure they have 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 have my facts right).

This new rule fixes some of the problem. Though this “get NAV of previous day” is downright stupid – I know 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 rich are used to being pampered, so it’s got to go step-by-step.

The new rule hurts brokers and rich investors who wanted to take advantage 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 make a percentage of assets, regardless of the losses to the other investors. They’ll all surely blame the lack of RTGS after 2 pm or some such random excuse, but they can’t be allowed to hurt other investors regardless. I am sure RBI needs to look at 24 hour real-time money transfer systems as a goal too, or at least expand to a bigger window than current – and all such regulation will provide a basis 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 invest before 3 pm). The concept is that equity settlements on the stock exchanges happens one day later anyway – if a fund buys stock, it needs to pay up the next day, by which time 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 current environment (call money rates at 6.8%!). Here’s hoping more of those returns come to us.


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