Many of you ask us how you should invest in mutual funds for the short term. This could be for creating an ‘emergency fund’, ‘medical fund’, ‘funds to pay school fees’ or simply for parking money temporarily for the short term.
By now, most of you know that it is safer to use shorter duration funds for short term needs.
But the two additional questions that invariably follow your above needs are:
- “will my capital 100% safe if I invest in liquid/ultra-short/money market funds?”
- “Will I get better returns than FD in these funds?”
The answer to these questions are:
- No, your capital is never 100% safe in any mutual fund. If you’re looking for such safety, it is best to go with FDs and government-guaranteed saving schemes. But what is possible is to choose categories that have least risk. The key here is to understand what categories or funds are relatively lower or even lowest on the risk scale.
- The answer to the 2nd question is partly a no and partly yes, depending on the nature of fund category we are dealing with. But suffice to know that when you are looking for the lowest risk option in mutual funds, there is a high likelihood of such an option not beating your FD. In simple words, low risk can only come with low return.
If you tune your mind to the above responses and are still willing to explore options in mutual funds, then the next thing you need to know is how the fund categories stack in terms of risk-return.
For this you need to look at a fund category and the fund itself from the following perspectives:
- The average maturity of the fund and the yield to maturity
- The probability of negative returns over shorter time frames (based on historical returns)
- Reason for negative returns – interest rate movements and credit risk
(the above points are only to assess risk-return and not to assess the performance of a fund).
How mutual funds for the short term stack up
Many of you may not know about overnight funds because it is not a category that anybody talks about other than in corporate treasury circles. Overnight funds invest in debt and money market instruments papers with overnight maturities. Since nobody expects a bank or company or the government itself to go belly up suddenly in just 1 day, it is safe to assume that the risk in this category is the lowest. There is also no volatility as these are just buy and hold papers.
But this comes at a low return. Look at the table below. You will see at present (as of October 2020), the yield to maturity (the return from the interest on the underlying instruments if you hold the fund over the residual maturity of its papers – you can watch this video for more information) is lowest in the overnight category. Needless to say, lower risk and lower volatility play a role in lower return. Of course, in a low interest rate scenario such as the present one, the interest on short-term papers in general is also quite low.
You will see that as the average maturity goes up, the yield too starts looking marginally better. Floater funds typically have marginally higher maturity than the other short duration categories. But the average maturity significantly varies across funds in this category. These funds either buy floating rate instruments (where interest rates readjust to new scenarios) or use interest rate derivatives to take bets on rate movements.
The key takeaways here are:
- the longer the maturity, the higher the possibility of better returns. But longer the maturity, more volatile a fund is. Therefore, your choice of categories will determine whether your fund swings more or dips into negative zone.
- You should roughly align your holding time frame with the average maturity of the fund when it comes to investments for less 1 year. This is necessary to ensure you at least get the underlying coupon (interest) of the funds without being impacted by any volatility in the period in-between.
Instances of negative returns
In the table below, you will broadly see the link between lower duration (see average maturity above) and proportion of negative returns. In other words, short term funds with very low duration – like overnight and liquid have very low chance of negative returns. And even that reduces as you hold them longer. For example: liquid funds returns have a possibility of negative returns over 1 week but that reduces as you hold it for 1 month (which is roughly the average maturity of funds in this category).
Similarly, low duration funds, that have a far higher maturity have delivered negative returns even up to 6 months. The chances are low, but it is definitely not nil. Floating rate funds, on the other hand, have shown lesser proportion of negative returns even over 1- month periods simply because their floating rate (as well as derivatives) nature helps them readjust (or hedge) to rate changes faster.
The takeaway here is that if you do not align your holding time frame to the average maturity of funds, you will have a chance of losing capital. For example, past data says that there was a 14% chance that you would have lost capital if you had held low duration category funds for even 6 months.
But why does this happen?
Why do shorter duration funds have losses?
As is the case with all debt funds, credit risk and duration risk are the primary reasons for negative returns in short term funds as well.
Credit risk: The credit events from 2018-20 would have shown mutual fund investors that shorter duration funds too are not exempt from credit risk. In the previous point, categories such as low duration saw abnormally high instances of negative return primarily because of credit and less due to duration. So also, the ultra-short debt funds duration category. And it is important for you to know that there is a significant variation in the credit risk of funds even within a category.
Hence it is not prudent for you to label any of these categories as low risk without knowing what the fund holds. To give an example – Kotak Low Duration held about 18% of its holdings in papers below AA+. This is far higher than the category average of 6.8%. Similarly, ICICI Pru Ultra Short Term held 27% in papers below AA+ rating as opposed to category average holding of 6.4%.
(as an aside, many of you ask us why we recommend funds with 5% or even 8% holdings in lower rated instrument. You need to know 3 things here on how much is too much! One, how much it is relative to its category. Two, how much it is in relation to the maturity of the paper. Three, the fundamentals of the banks/companies with such lower rated papers and how they are backed. Sorry folks, you really need to know it’s not a matter of deducing risk simply based on number of lower rated instruments!)
The takeaway here is that even in a low average maturity fund, credit risk can enhance the possibility of negative returns or the risk of your losing capital. And remember, unlike duration risk, which can be reduced by holding to the average maturity, with credit risk, you simply don’t have the leeway in the short term to recover the losses from default/downgrade. Hence, the safest thing you can do is NOT TO LOOK at high returns or high yield when you invest for the short term.
Interest rate risk: Now, when it comes to duration risk, it might puzzle you as to why shorter duration funds should have duration risk at all. They do have duration risk because they hold some part of their portfolios in AAA-rated or sovereign papers that are probably a year or more in maturity. For example, ultra-short term funds held an average 19% in AAA-rated papers and about 27% in state central government papers. Both lend themselves to volatility, even if not as heightened as longer duration funds.
That means when interest rates move, you will see them showcasing volatility. For example, the 1-month return of ultra-short duration funds fell about 40-50 basis points during the sudden spike in rates in March 2020 post the lock down. A similar behaviour was seen earlier in September 2019 as well. In an ideal situation, all buy and hold funds (accrual funds) should gain when rates move up. However, when they hold instruments that are slightly longer on maturity and well traded, a rate hike causes prices to fall.
So, if you chose an ultra-short debt fund for 1 month holding in February 2020 – you would have lost capital in March 2020.
Don’t forget that it is these same instruments that also generate the additional returns in these shorter duration categories when there is a rate fall (and price rise).
The takeaway here is that quality instruments that a fund holds can also cause volatility and losses in the short term.
How to invest then?
We have a very detailed article on which categories to use for various time frames here. But here is a synopsis of what you should avoid and how you should go about investing for the short term; besides what we do.
- Avoid choosing funds for the short term based on high returns. For example, choosing banking & PSU debt or corporate bond or gilt funds for the short term is entirely avoidable, – even if they are highly credit worthy. Their duration risk can still cause capital loss for even up to a year.
- The categories we have mentioned in our tables in this article are the only ones that you should consider for short term. And these are the categories that can be a predominant part of your SWP portfolio if you are withdrawing immediately after investing. Refer our income generating retirement portfolio for higher tax bracket to know how we mix funds.
- Any fund with enhanced credit risk (we are not talking of 2% or 5% here) is strictly to be avoided, even if they fall in any of the categories we have mentioned. There is no thumb rule for this. You can either go with what we suggest or learn through experience 😊
- For time frames of less than a month – nothing more than an overnight and liquid fund is ideal. This means you can also consider FDs or even your bank savings account at this stage of the interest rate scenario. In increasing rate scenarios, expect funds to deliver marginally higher than banks.
- For periods over a month to up to 6 months – a combination is fine but with a good chunk of holding in liquid funds.
- For 6 months to 1-1.5 years have an approach of mixing all of these to generate optimal returns without risks.
- Look at your fund’s average maturity to understand if it is in line with your own time frame. When building a portfolio, what we try to look is whether the average maturity of the portfolio we build would be in line with the time frame we are suggesting. For example, a floater fund with an average maturity of well over a year may be part of a 1-year portfolio, provided we know that the other funds in the portfolio have lower maturity. This is something you should be cognizant of when you build your own portfolio.
- Remember the yield to maturity is not always what the fund delivers. Credit risk and duration risk change this pre-expense return. Do not let your investment advisor tell you YTM is the return of the fund.
At PrimeInvestor, we consider all the above factors, besides, liquidity cost and performance parameters when we build portfolios for emergencies or for shorter time frames. We look at the combinations which carry the least risk (in terms of negative returns) and yet generate optimal return within the prevailing rate scenario.
And we do not seek to generate the ‘highest return’ for the short term. That does not come without risk of negative returns. And even with such conservative measures to construct a portfolio, we only meet you halfway in your expectation of ‘100% safety’!
Other articles that might help you understand debt funds better.
P.S: When should you use short-term debt funds even for the long term? At what point of rate cycle is this best done? Do await our strategy on this, based on the current and impending rate scenario soon. For subscribers only. Subscribe today if you are not a PrimeInvestor.