The Basics and Benefits of Short-Term Mutual Fund

Posted by Shaheen Shaikh on July 24th, 2021

Are you looking to invest your funds for a short duration while seeking reasonable returns? If yes, short-term funds are highly suitable as they offer you better returns than your savings bank account and short-term fixed deposits. Highly liquid because of their short duration these mutual funds invest in low-risk instruments. The duration of these funds depends on the maturity period of the underlying instruments- mostly debt and fixed income options.

Investors can invest in liquid funds and short-term mutual funds via:

• The dividend option- In this case, the income earned from this investment is exempted from tax.
• The growth option- The income earned from the funds is considered as part of the investor’s total income and so taxed accordingly

Short-term mutual funds can be of many types depending on their Macaulay duration.

What is Macaulay Duration?

As per SEBI rules, the mutual funds in India need to classify their debt schemes based on their Macaulay duration. This concept is a measure of how long it takes for the price of a bond to be repaid by the cash flows from it. In simpler terms, it refers to the time in which an investor will get back all his invested money in the bond by way of periodic interest as well as principal repayments.

The Macaulay duration for a portfolio is calculated as the weighted average time over which the cash flows on its bond holdings are received. This concept is important because bond prices are inversely related to interest rates.

When interest rates rise, bond prices fall and vice versa. While a bond with a longer maturity is more sensitive to interest rate changes, a bond with a shorter duration is less sensitive. This means that investors should stay with funds with longer maturity when interest rates are expected to fall and move to funds with short maturity when interest rates are either expected to be stable or rise. This makes it important for an investor to know the Macaulay duration of a fund and the risk involved.

The short duration debt funds have been categorised based on their Macaulay duration intoultra-short-term funds,low-duration funds, and short-term funds.

Ultra-Short-Term Funds

These funds invest in debt and other instruments like commercial paper, certificates of deposits, and treasury bills for a period of 3 to 6 months. The returns from these funds are generally a little higher than the liquid funds.

This category of mutual funds should be used for short-term investment purposes or systematic transfer plans (STPs) for investment in equity funds. Investors can choose to either put all their funds in an equity fund in one go or invest in an ultra-short-term fund and transfer a regular sum from there into an equity fund.

Low-Duration Funds

These funds invest in instruments with a maturity duration of 6 to 12 months to offer liquidity and return at moderate risk. These funds are liquid investments that are suitable for a time horizon greater than that of liquid funds and ultra-short debt funds.

Short-term Funds

This category of funds invests in instruments such that the Macaulay duration of the portfolio is between 1 to 3 years. The investment is done in companies with a proven track record of timely repayments and adequate cash flows to justify their borrowings.

Invest in short-term mutual funds to enjoy greater liquidity and earn good returns.