If you have been investing in mutual funds for some time now, then you must be familiar with the sub-components of debt funds like gilt funds, income funds, credit funds, liquid funds, ultra short term funds, short term funds, allocation funds etc. If you look at the latest SEBI categorization of debt mutual funds, then there are 2 distinct criteria for classifying debt funds; duration and credit quality. Let us look at benefits of ultra short term funds s well as short term funds vs ultra short term funds. We also need to understand short term mutual funds meaning as well as UST funds meaning.
In terms of credit quality, we can either opt for absolutely safe gilt funds or we go higher on the risk scale in search of higher yields. When we talk of credit quality, we are only talking about the credit risk or the default risk of the debt that the fund invests in. We are not talking about the interest rate risk. That is a separate discussion altogether. Let us now shift our focus on funds based on time or duration, to be more precise.
Liquid funds, short term funds and Ultra short term (UST) funds
Liquid funds and short term funds are at the lowest end of the duration spectrum. We can define liquid funds and short term funds as under. Liquid funds invest in very short term debt instruments and look at a typical maturity period of 15 days to 91 days. They are free of any kind of interest rate risk or market risk. They typically invest in call money, Commercial paper, certificates of deposits, treasury bills etc. Short term funds; on the other hand invest in debt instruments with a residual term to maturity of 1 year to 3 years. Compared to liquid funds, these short term funds have a slightly longer duration. The risk is in a short term fund is slightly higher in case of short term funds as there is an element of interest rate risk in these short term funds. Liquid funds are virtually free of interest rate risk. However, the short term funds also yield higher returns compared to pure liquid funds.
Liquid fund and ultra short term funds exist at the lowest end of duration spectrum. While liquid funds invest in bonds with a residual maturity of 15-91 days, the USTF invests in bonds with a residual maturity of 91 days to 365 days. The USTF will rank somewhere in between the liquid fund and the short term fund. In terms of return and risk, the USTR is marginally higher on the scale compared to the liquid funds, but below the short term funds in terms of duration risk and returns.
What monies can you park in ST funds and UST funds?
AT the lowest end of the duration spectrum, liquid funds are good to park short term monies. Typically, when you have a tax payable at the end of the month like GST, you can invest the same in a liquid fund rather than in a bank deposit. Short term funds will be better for investors who want to park their monies for a period of 1-3 years. It needs to be remembered the the debt profile of short term funds is longer than liquid funds and as a result there is an element of interest rate risk in short term funds whereas it is negligible in case of liquid funds. Only the monies that you do not want to withdraw in the next 1 year can be allocated to ST funds. Monies that you do not require for a period ranging from 3 months to 12 months can be parked in UST funds. You can calibrate your distribution accordingly.
How they rank on Total expense ratio (TER) and exit loads
The total expense ratio (TER) in case of short term funds is higher compared to the liquid funds. One of the basic reasons for higher costs in ST funds and UST funds is that liquid funds are not required to mark their holdings to market whereas short term funds and UST funds are required to provide for MTM on a daily basis. This makes the short term fund a lot more volatile compared to the liquid fund. Then there is the added challenge of exit loads. Liquid funds do not attract exit loads. That makes entry and exit quite seamless. That is why, even for systematic transfer plans (STPs), liquid funds are more appropriate. On the other hand, most short term funds charge exit loads if the fund is not held for a period of a minimum of 3-6 months. Same is the case with UST funds also.
Liquid funds are essentially about parking emergency funds for slightly higher than bank savings account returns. Companies need to earn something out of safe monies that is required to pay salaries, wages, taxes, interest etc. These can be parked in a liquid fund. What about short term funds? Short term funds and UST funds can be mixed with liquid funds to add more alpha capabilities to your emergency corpus.