If you have surplus money that you're not going to use immediately, but are sure of its need arising in the near term, say 6 months, you can consider parking the sum in Ultra short duration funds.
Ultra Short Duration Funds are suitable for investors looking for returns better than their bank savings account, which can nearly match interest rates on short term deposits, and give you adequate liquidity at the same time.
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What are Ultra Short Duration funds?
Ultra short duration funds are debt mutual funds that invest in debt and money market securities such that the Macaulay Duration of the scheme portfolio is 3 months to 6 months. These funds can generate higher returns than liquid funds, though at a slightly higher interest rate risk. The probability of making losses in ultra short duration funds lowers when you investment for 3 months or more.
Therefore, when you invest in ultra short duration fund ensure that you have an investment horizon of 3 months to 1 year. For investment horizon less than 3 months, Liquid Funds can be a better alternative.
For illustration purpose only
On risk-reward front, ultra short duration funds are among the least risky in the debt mutual fund category, except liquid and overnight funds. In a rising interest rate scenario, short term debt categories such as ultra short duration funds are more reliable compared to long term debt categories, and may even generate higher returns.
Notably, due to the accrual strategy followed, ultra short duration funds can generate decent returns with adequate liquidity across interest rate cycles.
Table: Performance scorecard of Ultra Short Duration Funds
Data as on March 25, 2021
(Source: ACE MF)
*Please note, this table only represents the best performing Ultra Short Duration Funds based solely on past returns and is NOT a recommendation. Mutual Fund investments are subject to market risks. Read all scheme related documents carefully. Past performance is not an indicator for future returns. The percentage returns shown are only for an indicative purpose. Speak to your investment advisor for further assistance before investing.
As we can see in the table above, ultra short duration funds have generated reasonable returns and hence they can be considered for meeting one's liquidity needs. However, choosing the right scheme is essential, as you do not want to invest in a scheme where you might risk losing your capital.
In the past, some funds in the category were caught off-guard when several underlying securities (such as Vodafone-Idea, Altico Capital, IL&FS, etc.) faced rating downgrades. As a result, the performance of those funds hit a rough patch.
Since the holding period of such funds is low, a significant write-off of a particular asset in the portfolio means that investors have to hold on to their fund longer than expected to recover from losses. Thus, evaluating the quality of portfolio is of utmost importance to mitigate any credit risk.
As an investor, you should ask these crucial questions to ensure that you invest in a worthy ultra short term fund:
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✓ Is the quality of the securities held in the portfolio reliable?
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✓ How reliable are the ratings assigned?
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✓ What if the rating assigned to particular debt paper slips; does the fund house have adequate risk management measures in place in such a case?
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✓ Does the fund manager compromise on the liquidity aspects?
When you select an ultra short duration fund, ensure that it prioritises safety and liquidity over chasing returns. Take the time to thoroughly assess the fund's portfolio. A fund may have delivered higher returns compared to its peers, but determine whether it was driven by a smart portfolio strategy, or was it because the fund manager chased higher yields by taking higher credit risk.
Best ultra short duration funds to invest in 2021:
Some of the best ultra short duration funds based on our analysis and research at PersonalFN are:
- Canara Robeco Ultra Short Term Fund
- IDFC Ultra Short Term Fund
- Motilal Oswal Ultra Short Term Fund
- PGIM Ultra Short Term Fund
- Principal Ultra Short Term Fund
Do not fall for ultra short duration funds that have higher allocation to moderate rated instruments or those investing predominantly in instruments issued by Private issuers. If your preference is safety over returns, you should consider funds primarily focusing on Government and Quasi-government securities.
You should ideally avoid investing in schemes that have significant exposure to longermaturity securities in short term categories such as, short duration debt funds, ultra short duration funds, low duration funds, etc.
[Read: How Mutual Funds Are Approaching Debt Securities in the Present Times]
In addition, ensure that the portfolio is well diversified across a range of securities and that it is not concentrated towards a certain company or group of companies.
Furthermore, avoid selecting schemes based solely on its recent performance because it may not generate similar performance going forward.
Most importantly, always give higher importance to fund houses that follow robust investment processes and systems along with sound risk management techniques in place. It is crucial that you understand the overall philosophy of the fund house; whether they aim to create wealth for investors, or are they in a race to garner more AUM by showcasing higher returns generated from chasing higher yields and taking higher risk.
Watch this short video on the lessons an investor can remember while investing in Debt Mutual Funds.
Outlook for Ultra Short Duration Funds in 2021
The Union Budget 2021 focused on pro-growth measures and making structural reforms to get the economy back on track. It provided an extensive spending plan on long-term projects including infrastructure, capex, and healthcare, which comes at a cost of higher fiscal deficit. The government has also announced a higher borrowing programme at Rs 12.05 trillion for FY 2021-22.
The higher borrowing target for the next fiscal year is expected to push bond yields higher. As you may be aware, bond prices and yields are inversely related. A surge in yield will impact bond prices negatively, which leads to a loss in the investors' value.
Moreover, the RBI has reduced repo rate by 115 bps and reverse repo rate by 155 bps during the pandemic. The fall in yields to a multi-year low had led to a rally in bond prices; however, with yields at an all-time low, the return expectation on debt funds has diminished.
The longer duration instruments are more sensitive to interest rate changes as compared to shorter duration instruments. Remember that Debt funds with exposure to medium to longer duration instruments tend to be more volatile in a scenario where there is an upwards movement in interest rates.
Debt funds that have exposure to longer maturity instruments may be highly volatile going forward, while those focusing on shorter maturity instruments (such as ultra short duration fund) and following an accrual strategy may still be better-placed to tackle the interest rate risk.
Therefore, in the present scenario, you would be better off investing in short debt categories such as ultra short duration fund (depending on your investment horizon) that do not have high exposure to private issuers.
PS: If you are looking for quality mutual fund schemes, I recommend subscribing to PersonalFN's premium research service, FundSelect. Currently, with your subscription to FundSelect, you could also get Free Bonus access to PersonalFN's Debt Fund recommendation service DebtSelect. Read full details here...
Warm Regards,
Divya Grover
Research Analyst
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