How do ultra short term funds fit into your overall portfolio

Ultra short term (UST) funds are a form of debt funds which are more tilted towards the shorter end of the yield curve. For most mutual fund investors this is a very important compromise between the liquidity of liquid funds and the higher returns of debt funds. Let us first look at the difference between short term vs ultra short term funds. What are the key benefits of ultra short term funds? Here is how to invest in ultra short term funds and how they fit into your overall mutual fund portfolio.

How do ultra short term funds rank on the risk return scale?

As the chart above indicates, in terms of risk-return trade-off, the ultra short term funds are almost at par with liquid funds. They are slightly lower than the short term fund but the advantage that the ultra short term funds offer is that you typically exit these funds without any exit loads. This makes ultra short term funds ideal for doing a systematic transfer plans and for institutions and corporates to park their short term funds for brief periods. 

Ultra Short term funds are not liquid funds

While ultra short term funds rank at par with liquid funds on the risk-return scale, they are not exactly the same as liquid funds. It is good to begin by understanding what Ultra short term funds are not. For example, a liquid fund would typically invest in short term debt with a residual maturity of less than 91 days. Ultra short term funds have a much broader range and can invest from 7 days to 18 months. Unlike liquid funds that are virtually money on tap, ultra short term funds will be better for investors who want to park their monies for a period of 1 month to 9 months. Since the debt profile of ultra short term funds is longer than liquid funds, there is an element of interest rate risk in ultra short term funds whereas it is negligible in case of liquid funds. When interest rates become volatile, ultra short term funds could be more volatile compared to liquid funds. What it basically means is that the NAV of a liquid fund will be more steady and consistent whereas an ultra short term debt fund could see elements of volatility in NAVs.

Costs involved in ultra short term funds

Obviously, the costs involved in ultra short term funds are slightly higher than liquid funds. The total expense ratio in case of UST is marginally higher compared to the liquid funds. Remember, liquid funds are not required to mark their holdings to market whereas UST funds are required to mark their portfolio to market on a daily basis. This creates volatility risk in the stock. Then there is the issue of exit loads. Liquid funds, by default are free of exit loads. That makes entry and exit quite seamless. While UST funds also offer the free exit load option, there are some UST funds that may charge a small exit loads if the fund is not held for a period of a minimum of 1-3 months as the case may be. These costs become quite important when you are looking at using these UST funds as a base for systematic transfer plans (STP) or in case of systematic withdrawal plans (SWP).

Some risks you need to be aware of in UST funds

There is a lot of leeway for the fund manager in structuring the portfolio of the UST fund. As a result some risks may creep into an UST fund without your really being aware of it. Firstly, some UST fund managers tend to actively manage the maturities based on their interest rate and liquidity outlook. For example funds typically oscillate their assets from a few days to a few months. Secondly, there is the risk of UST fund managers trying to search for higher returns by going down the credit quality curve. This may give higher returns but comes at a higher risk too. Lastly, most UST fund managers try to create alpha by taking a view on interest rates. Typically, when rates are likely to come down they add on more of longer dated G-Secs to make the best of NAV appreciation. Such active management adds risk to these UST funds and you need to be aware of the same.

So how exactly can an investor use the UST funds? There are 3 ways. Firstly, it can be combined with liquid funds to add more spunk to your emergency funds. Secondly, if you are looking at 3-6 month bank deposit, then a UST fund can be a more productive option. Lastly, when you do STPs or SWPs the return on the debt fund also matters. Here you can replace the liquid fund with UST funds to add to your eventual portfolio returns!