Why settle for less, if you are getting more? We tend to adapt to alternatives which are more productive. The same story applies to investment decisions as we tend to invest in financial products which may earn more, albeit they come with their own risks. One category is liquid/ultra short-term funds which score over the traditional short-term fixed deposits, current accounts and saving accounts.

Interest rates may not drop in the near future in India as many macro-variables such as fiscal and current account deficits are at a dangerously high level. So, liquid/short-term funds will continue to score over current/savings accounts in terms of returns.

What are liquid/ultra short-term funds?

These funds invest in safe debt and money-market instruments such as certificates of deposits (CDs), commercial papers (CPs), Treasury bills, call money and repo and reverse reposand have short maturities. While liquid funds maintain a portfolio average maturity of up to 60 days, ultra short-term funds have the leeway to maintain a higher average maturity of up to 365 days. Though most liquid and ultra short-term funds don’t have an entry or exit load, some ultra short-term funds’ exit loads range from three days to three months.

Inherent risks

Though portfolios of these funds are short-term and highly rated (P1+ or A1+), signifying strong protection against losses from credit defaults, they cannot be considered as totally risk-free as the liquidity pattern and short-term interest rates make these funds vulnerable. You also need to be cautious about the quality of instruments.

These funds’ returns are linked to short-term rates as most of them invest in short-term instruments. So, the returns are directly linked to returns of instruments such as CPs, CDs, Treasury bills, call money and repos. Expenses in liquid and ultra short-term funds range from 0.1 per cent to 1.3 per cent and 0.19 per cent to 1.42 per cent respectively. Currently, short-term rates range from 8 per cent to 9 per cent; so, one can expect pre-tax net return of short-term return minus expenses. Active fund-management skills also play an important role in generating additional returns. Their returns are currently superior to savings-account rates which range from 4 per cent to 6 per cent.

Tax advantages

Bank savings-account returns are taxable according to a person’s marginal tax rates irrespective of the holding period. For liquid and ultra short-term funds, dividend distribution taxes are 27.04 per cent and 13.54 per cent respectively. If investors plan to hold it for less than a year, they should opt for the dividend option; else they can opt for the growth option where they can also claim for indexation benefit further reducing the tax liability.

Mutual funds, too, provide online investment facilities. So, the ease of an online click including physical offline facility allow investors in earning extra returns in liquid/ultra short-term funds over current/savings accounts.

For any redemption request put before 3 p.m. online or offline, redemption payouts reach the investor’s linked account the next day.

(The author is Senior Manager, Research and Advisory, Motilal Oswal Wealth Management.)

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