8.1 Fair Valuation Principles

Why Valuation Is a Fairness Question

NAV is the price at which investors buy and sell units. If a scheme's assets are overvalued, an investor redeeming today takes out more than their share and the remaining investors are left worse off. If undervalued, the redeeming investor is short-changed and new subscribers get a windfall.

So valuation is not an accounting nicety. Every valuation error transfers wealth between one set of unitholders and another. That is the reasoning behind SEBI's insistence on principles rather than mechanical rules.

The Principle

SEBI's framework requires that portfolio securities be valued at fair value: the price that would be received on selling an asset in an orderly transaction between market participants at the valuation date.

The framework's defining feature is its override:

Where a prescribed valuation method would not result in fair valuation, the AMC must deviate from it and value the security at fair value, documenting the reasoning.

This reverses the usual compliance logic. Following the rule is not a defence if the outcome is unfair. The principles are:

• Valuation must reflect the realisable value of assets
• Methods must be applied consistently, and any change justified
• Valuation must be independent of fund management
• The AMC and trustees are responsible for true and fair valuation
• Deviations must be documented and disclosed

Valuing Traded Equity

Straightforward where a market price exists:

• Valued at the closing price on the principal stock exchange on the valuation day.
• Where a security was not traded on the principal exchange on that day, the closing price on another exchange is used.
• Where it was not traded on any exchange on that day, the last available closing price is used, provided it is not older than the prescribed period; beyond that the security is treated as non-traded and valued using good-faith methods based on fundamentals.

Thinly traded equity is identified by prescribed volume and value thresholds, and is valued on a fair-value basis rather than at a price set by a handful of trades.

Valuing Debt and Money Market Securities

This is where the greater difficulty lies, because most Indian corporate debt does not trade daily. A bond may not trade for weeks, so "last traded price" would be meaningless.

The framework's answer is independent valuation agencies appointed through AMFI, which publish daily security-level valuations for debt and money market instruments. Every AMC uses these.

Two consequences the exam expects:

1. The same security carries the same value across every fund house. Two schemes holding the same bond cannot report different values for it, which removes the scope for discretionary marking.
2. A debt scheme's NAV can move on a day when nothing traded, because the valuation agency's yield curve moved. Investors find this counter-intuitive and it is a routine question for a distributor.

Valuing Other Assets

Interest Rate Movements and Debt NAVs

Because debt securities are marked to market daily, a debt scheme's NAV falls when yields rise. Investors who bought a debt fund believing it works like a deposit are surprised, and the explanation is worth having ready:

"The fund holds bonds paying a fixed coupon. When new bonds are issued at higher rates, the older bonds become less attractive, so their market price falls until their yield matches. The fund revalues its holdings at market prices every day, so the NAV reflects that. If the bonds are held to maturity and no issuer defaults, the fall reverses as they approach maturity."

Deviation and Disclosure

Where an AMC deviates from a prescribed method to achieve fair valuation, the deviation must be documented, approved and disclosed on the AMC's website. Publication is what makes the override safe: an AMC may depart from the rule, but everyone can see that it did and why. Without the disclosure requirement the override would be an invitation to convenient marking.