Investor Corner/The wider picture/Risk, Regulation & Advanced Ideas
5.3.8 Fair Valuation
Fair valuation is the technique funds use to price securities when markets are closed or a security is not actively traded. Instead of relying on a stale last traded price, the fund estimates a more reasonable current value.
Why last traded price is not always good enough
If a security has not traded for several days, its last traded price may no longer reflect its actual current value, especially if broader market conditions have shifted meaningfully in the meantime. Using that stale price anyway would mean a fund's NAV does not genuinely reflect the true value of what it holds on that particular day.
Fair valuation is the process of estimating the true market value of a security when its last traded price may not reflect its current worth. This is relevant primarily for debt funds holding bonds that trade infrequently. If a corporate bond last traded three weeks ago, its market conditions may have changed significantly since then: interest rates may have moved, the issuer's credit profile may have shifted, or market liquidity may have dried up. Using the stale last-traded price in the NAV calculation would misrepresent the fund's actual value.
How fair valuation addresses this
Funds apply defined, regulator-approved fair valuation methodologies in these situations, using comparable securities, broader market movements, and other relevant available inputs to arrive at a more reasonable current estimate of a security's value, rather than simply defaulting to whatever price it last happened to trade at.
SEBI mandates that AMCs use fair valuation for securities where market prices are not available or are not reflective of true value. Valuation agencies (CRISIL, ICRA, AMFI) provide daily fair valuation matrices for corporate bonds based on credit rating, residual maturity and prevailing yield curves. AMCs use these matrices to mark-to-market their debt portfolios. The process is imperfect but aims to ensure that the NAV at which investors buy and sell units reflects the best available estimate of the portfolio's actual worth.
Why this protects all investors fairly
Without fair valuation, an investor redeeming on a day when a stale, outdated price happens to overstate a security's true value would receive more than their genuinely fair share, at the direct expense of investors who remain in the fund. Fair valuation exists specifically to keep NAV calculation equitable across everyone in the fund, regardless of exactly when any individual investor happens to transact.
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Fair valuation becomes contentious during credit events. When an issuer is downgraded or defaults, the fair value of its bonds drops sharply. The speed at which the AMC writes down the affected bonds affects the NAV and therefore the returns experienced by investors who were holding at the time versus those who redeemed just before or after. SEBI's side-pocketing framework (covered separately) addresses the most severe cases, but the broader principle of fair valuation applies to everyday NAV calculations for all debt funds. Investors in debt funds should understand that the NAV reflects estimated values of potentially illiquid securities, not the guaranteed realisable cash value of the portfolio.