For all their similarities, debt funds are not all alike. Ideally, to identify the right fund to invest into, one should have a thorough understanding of the risks involved in investing in debt funds and how to assess these risks. This becomes all the more important because, in my opinion, the potential heartburn from selecting an inappropriate debt fund can be far more than in the case of any other category of funds. While, over time, I hope to devote posts to talking about these risks and how to assess them, in this post, I’d like to present a straightforward way to understand the types of debt funds and their suitability.
Let me start by suggesting that debt funds can be grouped into three broad categories:
Category A: Closed-end schemes
Category B: Open-end schemes where the fund manager can make significant changes to the average maturity
Category C: Open-end schemes where the fund manager intends to keep the average maturity within a narrow band
This is not a textbook classification but I believe it is the best way to assess the suitability of a fund. To facilitate understanding as to which funds fit in what category, I will be linking these with the categories put forth by Value Research. You may notice a certain ambiguity to the definitions (what, for instance would ‘significant’ or ‘narrow’ mean?)- but interpreting these will be less relevant once I link these to the categories of Value Research.
Let me now elaborate on these categories.
Category A : This is really the same as Value Research’s category: Fixed Maturity Plans. Like deposits, these funds have a fixed tenure. Amongst all categories, these carry the highest level of predictability as to the returns one can expect. The returns on such funds virtually mirror the returns of the underlying debt instruments. This is a key reason why a number of advisors strongly encourage their clients to invest in these funds.
On the flip side, these funds typically carry severe restrictions in case we need to withdraw before the term of the fund. It is possible we may not even be able to do so. For this reason, these are best suited for investors with crystal clarity about the time they would like to stay invested. The right fund is one whose tenure matches one’s own investment time horizon.
Do bear in mind that at the time of investing, we do not know the exact composition of the portfolio of the fund. Once the portfolio is disclosed, if we don’t like what we see, it may not be easy to walk out. It, therefore, becomes important to get as much clarity as we can, about what the portfolio will look like, before we invest our money. Additionally, at the end of their tenure, these are compulsorily redeemed- we cannot defer exiting the fund beyond that time. This is important because taxes, if any, become due the moment we redeem an investment.
Category B: This would include funds in the following categories of Value Research: Income, Gilt-Medium and Long Term, and Gilt-Short Term.
These funds are best suited for investors who are looking for the highest returns (among debt funds) and are willing to take higher risk, and to time their entry into, and exit from these funds. To put it differently, these funds are an acquired taste- these are not for everyone. These carry the highest level of unpredictability as to the returns one can expect. Historical 1 year returns show that it is not uncommon to see a double-digit difference between the returns of the best performing and the worst performing funds, particularly in the Income and Gilt-Medium and Long Term categories. In the turbulence of mid-July to mid-August, 2013, the worst performing funds in each of these three categories had lost between 5% and 12%.
Category C: This would include funds in the following categories of Value Research: Liquid, Ultra Short Term, and Short Term. Like the funds in Category B, being open-end schemes, these allow one to defer one’s exit (and taxes) for as long as one wants to. But because of their targeted maturity being more narrowly defined than those in Category B, there is a higher level of predictability to their returns.
Here is how I look at their suitability, relative to comparable bank deposits:
- For someone with an investment horizon of up to 3 months, funds in the Liquid category can be a good choice and, in my opinion, can be expected to give better returns than a bank deposit.
- For someone with a investment horizon of over 3 months and less than a year, funds in the Ultra Short Term category can be a good choice and in my opinion, can be expected to give better returns than a bank deposit.
- For someone with a time horizon of over a year but less than 3 years, I would recommend going for a bank deposit rather than a debt fund.
- For someone with a time horizon of over 3 years, and with no taxable income or who is in the lowest tax bracket, I would again recommend a bank deposit over a debt fund.
- For someone with a time horizon of over 3 years, and in the higher tax brackets, funds in the Ultra Short Term and Short Term categories can be a good choice and can be expected to give better returns than a bank deposit, after adjusting for taxes.
To take all of this further towards deciding which specific fund to select, as I mentioned at the start, it would help to understand the risks involved in investing in debt funds and how to assess these risks. I hope to dwell on these in detail in future posts. For now, I would like to close with a mention of one important indicator to consider while selecting a fund: the expense ratio.
The expense ratio tells us how much is deducted as expenses by the fund house from whatever they have earned from their investments. While this is an important indicator across all kinds of funds, it is particularly crucial in the context of debt funds. Here’s one way to look at this: if two funds follow identical strategies and take identical risks, the fund with the lesser expense ratio will give better returns. A note of caution: As important as this is, in my opinion, there is generally a lack of transparency regarding this indicator across the mutual fund industry. Though, in all fairness, Value Research and Morningstar provide this indicator for most funds, most fund houses don’t disclose this in their monthly fact sheets.
For that reason, personally, I focus only on funds where the expense ratio is disclosed transparently, month after month, in their fact sheets.
