Ultra Short Duration Funds

Ultra Short Duration Funds

What are Ultra Short Duration Funds?

Ultra Short Duration Funds are those debt mutual funds which invest in debt securities & money market instruments such that the Macaulay duration of the portfolio is between 3-6 months. These funds have comparatively longer maturities than overnight & liquid funds and shorter maturities than other categories of debt mutual funds. The short maturity of ultra-short duration funds makes them one of the very low-risk investment options in the debt space. These funds carry the potential to offer higher returns than a typical savings account as well as Fixed Deposits of similar durations.

As per recent data, the returns from ultra-short duration funds have been higher than FDs in most of the banks for similar durations.

Features of Ultra Short Term Funds

Portfolio

The ultra-short duration funds make investments in debt & money market instruments in a way that the Macaulay duration of the portfolio is between 3-6 months. In simple terms, the Macaulay duration of a portfolio is the weighted average time period taken by its underlying securities to recover the initial investment through internal cash flows including interest & principal repayments.

Costs

The expense ratio of ultra-short duration funds is in the range of 0.08% to 1.60% of total assets under management for different funds. These funds do not charge any exit loads on redemptions which allows investors to withdraw anytime as per their requirements without incurring any costs.

Risk

The short maturity of underlying securities in ultra short term funds results in lower overall risks in the portfolio. The volatility can be higher in these funds as compared to other debt categories with shorter maturities.

However, the short maturity does not guarantee low risks as the fund manager might take some exposures in low-rated papers to increase yields which in turn could increase overall risks in the portfolio.

Talking about interest rate risks, low durations in these funds make these funds less sensitive to interest rate movements in the economy.

Returns

The ultra-short duration funds have the potential to offer higher returns than bank fixed deposits of similar maturities. 

With the falling interest rates in Bank FDs, Ultra short duration funds can be a good option to park money for a short horizon to earn better returns.

Currently, the Yield to Maturity (YTM) of Ultra Short Duration Funds is in the range of 3.2%- 5.22%. 

Factors to consider while investing in Ultra Short Duration Funds

• Expense Ratio

The YTMs of ultra short term funds is generally lower than other debt categories with long maturities. So, it is important to consider the expense ratios of the funds so as to have higher efficient returns post expenses.

However, investors should not only consider the expense ratios as the fund might be charging higher expenses for delivering superior returns.

• Credit Quality

The credit quality of the scheme's portfolio should also be considered while selecting the ultra short term fund. Some funds might have taken large exposures in low rated papers & securities to offer higher YTMs which could increase the chances of defaults or capital losses in such funds.

Investors in ultra-short funds should aim to select the fund with major investments in high-quality papers such as SOV, AAA, etc. to reduce the overall risks.

• Performance

The historical performance of the fund, fund manager & AMC could also be considered. The fund managers who have delivered consistent & good returns on their funds over the years are expected to do the same in times ahead. 

However, past outperformance does not guarantee future outperformance so investors should wisely choose their investments only after analyzing different parameters like YTM, duration, credit quality, etc.

• Investment Horizon

Investors should consider their investment horizon before investing in these funds. Ultra short-term funds are suitable for investments for a tenure between 3-6 months. Investors who have a short horizon can consider liquid & overnight funds depending upon their tenure as they could offer better liquidity & risk measures.

And investors with a horizon longer than 6 months can consider investments in low duration funds, short term debt funds & other debt categories according to their investment tenure as they could offer better returns.

Taxation of Ultra Short Term Funds

Ultra Short Duration Funds invests predominantly in debt securities & money market instruments. So, they have the taxability of debt mutual funds. Following taxation is applicable:

• Units held for less than 3 years are taxed as per the slab rate applicable to the investors. The gains on investments are treated as Short Term Capital Gains.
• Units held for more than 3 years are taxed at the rate of 20%(LTCG Tax) after indexation benefits. The gains on investments are treated as Long Term Capital Gains. 

Who should invest in Ultra Short Term Funds?

Investors looking for low-risk investment options with an investment tenure of 3 to 6 months can consider investments in Ultra short duration funds. The potential expected returns can be higher than the interest offered on fixed deposits of similar tenures. 

Also, Investors who want to invest in equity mutual funds can consider a lump-sum investment in Ultra Short Duration Funds which they can later route to an equity fund of the same fund house through an STP (Systematic Transfer Plan). By using STP, investors will be able to make periodic investments in equity funds which will also reduce overall volatility & risks in investments.