Liquid Funds and Ultra Short Term Mutual Funds are both important categories of Debt Mutual Funds in India.
What is Ultra Short Term Fund?
Ultra short-term funds are a type of debt instruments with an average maturity period of over 91 days and under 1.5 years. The funds’ investment consists of treasury bills, commercial paper, corporate paper, and certificate of deposit. Certain funds may also go for corporate debt with lower ratings. The portfolio is usually made of varied securities that mature in 7 days to 18 months.
What is Liquid Fund?
Liquid funds are just like savings in a bank or having cash in hand. But compared to the interest given by your savings bank account, you can earn markedly higher interest for parking your funds, at an average of 6 to 7 percent returns. The fund investments consist of very short term debt securities that mature in less than 91 days. The fund does not pick long-term rate calls nor has investments in low-rated corporate bonds. They are thus debt funds with the lowest level of risk.
Difference between Liquid Funds and Ultra Short Term Funds
When buying liquid funds, investors will get the NAV or net asset value of the previous day if the funds get transferred before 14.00 hrs; if not then investors get NAV of the same day.
This option is unavailable with ultra short term funds; investors get the same day NAV if funds get transferred before 15.00 hrs, else the next day NAV is applicable. For both ultra short-term funds and liquid funds, investors will get NAV of the same day when the funds are redeemed before 15.00 hrs. The funds then get transferred to the investor the next day.
As liquid funds have lower duration/maturity period, they are regarded as being less risky than ultra short-term funds. Liquid funds have no need for mark-to-market, and valuation of NAV is calculated as per accrual basis via addition of the coupon accumulated for that day.
Parts of ultra short-term fund securities with over 90 days maturity period need to have mark-to-market, which means that variations in market price due to changing yields need to be recorded every day. This may result in extra NAV volatility. In most cases, the marked to market part of ultra short-term funds portfolio is kept low which subsequently reduces the effect of change in price.
Liquid funds are ideal for those who want to invest for very short durations ranging from 1 day to 3 months. Investors hold liquid debt securities portfolio with average securities maturity of not more than 91 days. It has minimal or no volatility and interest accumulates on the instruments held.
Ultra short-term funds also offer accrued income earnings from held securities. They however have longer average maturity period as compared to liquid funds. Its portfolio also consists of securities whose prices tend to oscillate on a daily basis. Hence over a short period of 30 to 60 days, they are comparatively slightly more volatile than liquid funds. Since the maturity period for ultra short-term funds is higher, investors need to hold them for 1 to 12 months.
For both type of funds, the short-term capital gains tax is calculated on the basis of the individual income tax bracket, while long-term capital gains tax rate is 20 percent along with indexation.
Effective use of investments in ultra short-term funds
Investments in ultra short-term funds is ideal for those who want to invest in equities but are seeking the right moment to enter and/or are not sure of the market direction in the future. Conversely, people who are concerned about high valuations of equity can make profits in equities and then invest it in ultra short-term funds before deciding on future moves.
Ultra short-term funds are also good for parking funds required for future lump-sum payments for purchase of real estate or other big assets. It can also be used for STPs or systematic transfer plans to create wealth.
Investors who desire to invest a large sum in equity funds but do not wish to do that at one go may park the amount in ultra short-term funds and forward directions to change to a regular amount per month to the equity fund. The best part about ultra short-term funds is the fact that investment earnings are somewhat higher than liquid fund returns.
There is no exit load on liquid funds and a majority of fund houses don’t levy exit load for ultra short-term funds. In some instances, a 0.1 to 1 percent exit load may be levied on ultra short-term funds by certain fund houses for a specific period ranging from 1 week to 6 months. This helps maintain the fund’s stability and better regulate the outflows. It also decreases volatility of NAV and is advantageous for small investors.