How do mutual funds arrive at fair valuations for your investments?

The Indian mutual fund (MF) industry touched a new high in assets under management (AUM), crossing the Rs 15 lakh crore mark in July. This corpus value is computed by mutual funds on the principle of 'fair valuation', as mandated by the Securities and Exchange Board of India (Sebi).

Fair valuation for price discovery

Fair valuation is the approximate price a security will fetch in the market on a particular day. It indicates that the security is marked to market (MTM). At a composite level, these MTM prices reflect in the net asset values, or NAVs, of mutual fund schemes at the end of every trading day.

It is comparatively easier to establish the true market value of equity investments (1/3rd of MF industry) as shares are widely traded and their prices easily available. The story is different for debt instruments (2/3rd of MF industry), especially corporate bonds, since that market is comparatively shallow (penetration at 17% of GDP versus 123% in the US). And within the corporate bond market, AAA category securities (or the top rated ones) account for 78% of trading.

So how do mutual funds arrive at valuations for these relatively illiquid securities? Debt instruments with maturity less than 60 days are amortised on a straight-line basis from cost or last valuation price, whichever is more recent, provided the amortised price is reflective of fair value by comparing it with the reference price. For longer maturities, securities that are not traded are valued based on scrip-based prices provided by independent agencies in association with the Association of Mutual Funds in India.

This system of fair valuation by mutual funds is similar to the requirement and principles laid down under Indian Accounting Standards (Ind AS), which is drawn up in convergence with the globally accepted International Financial Reporting Standards (IFRS).

About Ind AS:

Ind AS is aimed at enhancing transparency through more disclosures and improving comparability so that Indian companies can be assessed more accurately with their global peers. So far, corporates have followed different valuation approaches for fair value reporting in accordance with Indian Generally Accepted Accounting Principles or IGAAP, and there was no defined framework for measuring 'fair value'. The new standard, Ind AS 113 'Fair Value Measurement' aims to define fair value more clearly, provides guidance on valuation techniques and lays down a fair value hierarchy for inputs to be used for valuation techniques so that investors and other stakeholders get a more accurate picture of the company's current financial position.

Sebi has granted time till September for companies which would need to comply with Ind AS from this fiscal to report their earnings for the June quarter. For banks, insurance companies and non-banking financial companies, implementation will be from fiscal 2019.

According to a Crisil study, as many as 3,700 companies (includes listed and unlisted companies with net worth of Rs 500 crore and above, and their holding companies or subsidiaries) will need to comply this fiscal, while an additional 7,000 will follow suit in the next. A study by Crisil shows that as much as Rs 1.7 trillion investments across these 10,000+ corporates were in debt instruments. Considering there is a lack of liquidity in investible debt instruments, entities would need to adopt an appropriate and well-defined valuation technique to determine the fair value in order to avoid subjectivity in judgment.

In conclusion, Crisil believes Ind AS is in line with global best practices and a good step towards improving transparency in valuation of debt instruments, provided it is followed in true spirit. While mutual funds are nearly compliant with this norm already, the financials of the underlying companies would need to be modelled to reflect this new reality.

The writer is director - funds and fixed income research, Crisil Limited