Short Term Mutual Funds

Most investors associate mutual funds with long-term investments of at least three years. However, you cannot always keep your money locked in for so long. What can you do then? Invest in a short-term mutual fund. 

What are short-term mutual funds?

Short-term mutual funds are open-ended debt mutual funds that invest in debt securities for a short duration of one to three years. Some of the best short-term mutual funds in India are HDFC short-term mutual fund and Axis short-term mutual fund.

What do short-term mutual funds invest in?

These funds invest in a wide range of debt instruments such as government bonds, corporate bonds, derivatives, securitised debt, and bonds issued by public sector enterprises and financial institutions. They also invest in money market securities such as commercial paper, treasury bills, and certificates of deposits. The funds earn via capital gains and interest accrual. When the interest rate in the market reduces, the value of the securities held by these funds rises, leading to capital gains.

What are the advantages of short-term mutual funds?

• Risk: Due to the shorter duration of these funds, they are less subject to market volatility. Therefore, the interest rate risk is lower than those of medium to long-term duration funds and dynamic bond funds. The best short-term mutual funds allot most or a major portion of their corpus to AA graded debt investments. AA investments are deemed to be of very high quality with very low credit risk. The remaining portion, if any, may be invested in lower-rated debt investments to boost returns. Short-term mutual funds have moderate risk with a lower risk factor compared to other investment vehicles such as credit risk funds.
• Returns: These funds tend to generate steady returns for investors. Fund values tend to remain stable in the face of changing market rates. These funds can earn via higher interest income when rates in the market increase. They reduce any capital losses by shifting to short-term securities. When there is a decline in market rates, the short-term mutual funds then increase their exposure to long-term securities and so they earn capital gains. So the loss in income from interest is made up by an increase in capital gains.

Who should invest in short-term funds?

You should invest in short-term mutual funds if you 

• Have a shorter investment horizon: if you have a short-term horizon of one to three years. A longer horizon may benefit investors who want to get the best returns. If you redeem the units within a year you may end up exiting when interest rates are rising. If you have a shorter investment horizon, then it is better to invest in an ultra-short-term fund such as the Axis Ultra Short Term Fund, which has a duration of three to six months.
• Are a first-time investor in debt instruments: The returns on these funds are higher than those of overnight or liquid funds. Moreover, the volatility experienced by these funds is lower than those experienced by funds of a longer duration. So, short-term mutual funds can offer good exposure to investors new to debt as they deliver market-related returns and have moderate risk.
• Want regular income: As short-term mutual funds can deliver steady returns, you can use a Systematic Withdrawal Plan (SWP) to get a regular stream of income from these funds. 
• Want an alternate instrument for short-term savings: These short-term mutual funds have the potential to earn higher returns than other short-term savings instruments such as bank deposits. This is because they can earn capital gains as well as interest. They are also a better option than just allowing a corpus to sit in your savings bank account earning minimal interest per year.

How to find the best short-term mutual funds?

Look at –

• Returns offered: Track the returns of a fund on a one-year, two years, and three years basis. The fund should deliver higher than benchmark returns.
• Risk: The fund should allot a majority of its portfolio to the highest quality bonds (look for AAA or AA ratings). Funds investing in bonds with credit ratings below AA carry more risk but may also deliver higher returns. Check for how the fund manages duration as it will indicate how much exposure the fund gets to volatility. The volatility of the fund should match your risk tolerance.
• Expense ratio: Higher expense ratios mean that investors get lower returns as the expense ratio is subtracted from the returns.  Lower expense ratios are preferable for investors.

Summing up

A smart investor capitalises on every investment opportunity. Don’t let your money languish in a bank account earning minimal interest. Nor do you have to park your money for five to seven years to earn good returns. Invest in a short-term mutual fund today and earn well in a shorter timeframe.