Shorter Periods, Quicker Returns

Shorter Periods, Quicker Returns 1036 0

Where should an investor invest in order to fulfil short-term commitments? The article provides an in-depth look at the various options that are now available

Today’s rapidly evolving world poses different needs and challenges. Every individual’s requirements and financial goals differ, thus calling for unique and sometimes customised investing strategies to help them achieve their objectives. Within this sphere of financial outlays, there are both short-term and long-term goals which require different approaches. The short term goals could include buying a top-end gadget or a car or going for a vacation while long-term needs could include buying a second home or the higher education of a child. For short-term goals there are various instruments available in the market such as equity, mutual funds, fixed deposits, recurring deposits, etc. However, they are accompanied with risk and taxation.

Of all these instruments, short-term debt mutual funds can help you grow as well as achieve your short-term financial goals with lower risk and higher tax efficiency. Short-term funds usually have a term of maturity ranging from one to three years from the date of inception. Hence, investors seeking to invest for a shorter period of time can invest in mutual funds that offer such a timeframe. These funds therefore invest in securities, bonds and money market instruments, among others i.e. debt instruments with a maturity period in align-ment with the goal’s maturity period.

Here is a comparison of various investment options with short-term options:

1. Corporate Bonds : These bonds are issued by corporations to the public at large. Similar to a bank borrowing, the corpora-tion borrows from the general public by way of such instru-ments. Though the investment amounts are low and these are easily accessible to the public, corporate bonds are very risky. A normal individual investor does not have the knowledge to define the quality of the bonds. Also, the risk multiplies for the investor by investing all the money in such bonds even if they are of the highest quality. To be able to tackle this, an investor can diversify into multiple risk classes, outsourcing his work to a person with the required competence and knowledge and investing in short-term debt funds. This leads to better returns, lesser time consumption and proper diversification of the funds.

2. Fixed Deposits : Though fixed deposits are a safe way of investment and easily accessible through banks, the returns generated through fixed deposits are very less as compared to short-term debt funds. In India, fixed deposits offer interest rates from 4-5.5 per cent per annum while the annualised returns on overall basis of such funds are between 6-9 per cent per annum. There is also an advantage in the taxation of the returns earned. Returns redeemed after three years are taxed at 20 per cent after indexation of the cost of investments. How-ever, in case of fixed deposits, there is no indexation benefit to the investor. Hence, an investor enjoys the benefit of lower taxation on the returns earned with an already marginally higher return by taking a slightly higher risk.

3. Recurring Deposits : A person cannot deposit a huge amount at once for investment in a recurring deposit. In the case of recurring deposits, its returns hover around those offered by fixed deposit. In case of the short-term mutual funds, the investor can invest in regular payments i.e. SIP. As com-pared in the case of fixed deposits, the returns generated are higher than such deposits. Hence, an investor can gain much higher returns by taking a little more risk than a fixed or recurring deposit, also leading to a marginal gain in returns over risk.

4. Large-Cap Fund : Though large-cap funds are a great investment with lower risk as compared to other equity-orient-ed schemes, the fact remains that these funds are equity-based and hence the risk is a lot more than in the case of debt funds, especially in the short term. The high volatility combined with market sentiments could lead to great gains during times of boom but huge losses when the tables turn. Hence, the risk involved is very high as compared to debt funds. Also, except for the dividend paid, which is optional for the companies, there is no fixed income offered by the equity markets.

5. Post Office Time Deposit : This scheme is another type of fixed deposit. The investor can opt to deposit for one, two, three or five years. However, unlike banks, there is a single interest rate for all depositors with an interest rate of 5.5 per cent per annum for the short term i.e. one to three years. These returns can be easily outperformed by short-term duration funds at 7-9 per cent per annum.

Diversification Angle
A great advantage which short-term debt funds have over all the other instruments is that they diversify the investments rather than depending on a single one. Due to this, the fund manager can drive the returns upwards by investing in steady low-return instruments as well as high-risk instruments and even in securities with medium risk. This leads to a mix of all the returns and even if there is a default, the other instruments maintain the returns as there is a combination of different risk classes.

Types of Short-Term Debt Mutual Funds : Overnight Fund: It is an open-ended debt scheme investing in overnight securities. Investment in overnight securities has a single day maturity. These are suitable for investors who have an extremely short investment horizon. These funds are safe and are not affected by changes in interest rates. The following table depicts the top three overnight funds based on one-year return:

Liquid Fund: It is an open-ended liquid scheme investing in debt and money market securities with maturity up to 91 days. Liquid funds are ideal to invest surplus cash for a short period, say, up to three months. The following table depicts the top three liquid funds based on one-year and three-year returns.

Ultra-Short Duration Fund: It is an open-ended scheme investing in instruments with Macaulay duration between three and six months. These funds help an investor avoid interest rate risks but as compared to liquid funds these are quite risky. The following table depicts the top three liquid funds based on one-year and three-year returns.

Low Duration Fund: It is an open-ended fund investing in debt and money market securities such that the Macaulay duration of the portfolio is between six to twelve months. Low duration funds earn through a combination of interest and capital gains on their debt holdings. The following table depicts the top three liquid funds based on one-year and three-year returns.

Money Market Fund: It is an open-ended debt scheme investing in money market instruments with maturity of up to one year. Money market funds are considered a good place to park cash because they are much less volatile than the stock or bond markets. The following table depicts the top three liquid funds based on one-year and three-year returns.

Short Duration Fund: It is an open-ended debt scheme investing in debt and money market instruments such that the Macaulay duration of the portfolio is between one and three years. It is ideal for investors who want stable returns with moderate risk. The following table depicts the top three liquid funds based on one-year and three-year returns.

The advantages include:
• Liquidity: Debt funds enjoy higher liquidity as they have no redemption restrictions or locking of the money invested for the whole term, except for a predetermined period ranging from five days to six months.
• Higher Returns: Unlike the traditional fixed deposits, there is a diversification leading to investment in securities giving higher returns as well as steady low returns. This leads to an overall jump in the returns from such funds as compared to the fixed returns on fixed deposits.
• Taxation: The returns on such funds when redeemed before three years attract taxes as per the slab of the individual and in case of completion of three years the returns are taxed at 20 per cent after indexation of the investment.

The disadvantages include:
Exposure to Credit Risk: Due to the debt nature of the instru-ments, the risk of default looms higher in the case of such funds. Hence, there can always be a chance of loss of the investment due to the credit risk involved in the nature of such instruments.
Interest Fluctuation: Interest rate fluctuation is a major factor which determines the returns of debt instruments. In case the interest rates spike up, the value of the securities start diminish-ing. However, in case of interest rates going down, the resultant gain could be very high.
Inflation Risk: Returns from these funds are not as high that they always surpass the inflation rates. Hence, higher inflation might eat up the earned returns.

Conclusion
The underlining aspect of any financial strategy is that investors should assess their needs, investment horizon and expected return before investing in any instrument. Short-term debt funds can prove to be beneficial as they offer sufficient returns over the short term along with tax efficiency. There are various types of short-term mutual fund schemes available and you should invest in a type that is appropriate and suitable to your needs and profile. 

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