This new rule implies that the difference between the reference price valuations agencies such as CRSIL and ICRA provide and that considered by a liquid fund to calculate Net Asset Value (NAV) shouldn't be more than 2.5 basis points (bps).

A basis point is a hundredth of a per cent. By this move, SEBI has held up a mirror to fund houses and fund managers blinded by their outperformance over the past few years.

As you might be aware, many liquid funds took unnecessary risks when they overestimated their capabilities. Consequently, it's been the gullible investors who've borne the brunt.

[Read: Why Your Money In Liquid Funds Is At Risk?]

In the aftermath of demonetisation, easy liquidity made many fund houses and fund managers complacent. When investors started preferring financial assets to physical assets, many mutual fund houses believed their struggles were over.

They believed the inflows in the mutual fund were unconditional and liquidity warranted taking risks even in fund categories such as liquid funds, primarily designed for safety.

On the other hand, corporate issuers of debt securities also thought they could continuously raise money from mutual funds to meet their liquidity requirements.

After all, what does it take to draw out money from mutual funds? High credit ratings and some marketing skills to pull the wool over mutual funds' eyes.

New mark-to-market norms will possibly curb malpractices prevailing in the mutual fund industry and would perhaps act as the deterrent for complacent fund managers.

What mark-to-market valuation means?

In simple words, marked-to-market valuations reflect a security's current market value. As against this, the accrual system isn't concerned with a security's current market value, it rather accounts for gains that will be realised in the future.

And here's how it affects liquid funds...

The primary reason that many liquid funds incurred sudden losses in the recent past was because of following the accrual method of valuing securities up to the residual maturity of 60 days.

Are you wondering how a valuation method can lead to any loss?

Consider this scenario.

A liquid fund 'A' bought zero coupon bond with Rs 1,000 face value for Rs 975 which had a residual maturity of 55 days. Within a week after the liquid fund 'A' purchased this bond, another liquid fund, 'B', sold the same bond in a huge quantity for Rs 960. As there weren't many active buyers, the fund 'B' sold it at a discount.

Since the bond quoted at Rs 960, it was an unrealised loss of Rs 15 even for the fund 'A' too. However, instead of account for this unrealised loss, the liquid fund 'A' kept adding Rs 0.4545 every day assuming that it will be able to redeem the bond at the face value on the day of maturity.

Soon after, an independent rating agency slashed the credit rating of the bond, following which the bond price fell by Rs 50. Fund 'A' still didn't bother to factor in these changes.

This event, by now, has created a speculation about a potential default. This triggered massive redemptions from the liquid fund 'A' since by then everybody knew that the bond of a troubled company had a 15% weightage in liquid fund 'A's' portfolio.

To provide liquidity to investors, fund 'A' started selling other securities.

Eventually, the issuer of the bond couldn't honour the payment and suddenly fund 'A' incurred a massive loss due to write-offs.

Whether or not, the fund 'A' recovers its money from the bond issuer is secondary now. Because investors of liquid funds may not have a time horizon to wait until liquid fund 'A' negotiates with the issuer.

[Read: Are You Holding Debt Mutual Funds With Stressed Assets?]

Impact of new mark-to-market norms on liquid funds...

• So far some mutual fund houses were masking the credit risk profile of liquid funds by taking advantage of marked-to-market norms. But SEBI's new directive will put the brakes on a fund manager's complacency. Hopefully, the fund managers will invest in more liquid assets with a sound risk profile.

• The fund managers of liquid funds might become a little more conservative and, in general, the average maturity of liquid funds might reduce.

• Liquidity in non-government money market securities with a residual maturity of more than 30 days but less than 60 days, may reduce.

• To avoid credit risks and maintain consistency in returns, liquid funds may be more inclined to increase their exposure to government securities.

• On the positive side, new valuation norms will ensure there isn't much difference in the value of the security considered for calculation of NAV and the realizable value in the secondary market.

What will change for investors?

• As more liquid funds are anticipated to invest in high-quality papers with lower residual maturity, the instances of outperformance might reduce.

• Past returns may become irrelevant as fund houses will brass up for the regulatory changes. Liquid funds that took excessive risks to generate higher returns, may not be able to match their historic performance if they decide to be more prudent now.

• Nonetheless, returns would still be largely driven by systemic liquidity and RBI's monetary policy rate actions. Reduction in the returns due to a potential change in the maturity profile of portfolios of liquid funds might not be as significant as some media houses believe.

Verdict:

Do not stop investing in liquid funds; they haven't lost their appeal. In fact, they have now become more transparent, and the returns would be more realistic too.

[Read: The Best Liquid Funds For 2019]

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