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Posted by: Uma Shashikant on Mon, Mar 14th, 2011

MFs Focus on Retailing ST Debt Funds

The mutual fund industry is currently aggressively offering open-ended short term debt funds to retail investors  -  a belated but welcome development.  The default choice of most investors is a short term debt product. RBI data shows that 75% to 80% of all bank deposits are held in the 1-3 year horizon. Debt funds have mostly been offered to corporate investors with retail participation somewhat restricted to fixed maturity plans (FMPs).  FMPs from 91-day to 730-day maturities are being routinely offered, but a sharply increasing short term interest rate makes a later product more attractive than the current one, leading to missed investment opportunities for investors.  What funds are doing is to reposition existing products or offer new ones to offer a short term retail debt product to investors. IDFC MF has a Super Saver fund in this space, ICICI Prudential MF and Reliance MF have Regular Saving Funds, DSP Blackrock has re-positioned its monthly income plan as the Savings Manager Fund in this space, and Templeton Income Opportunities operates in the same space. 

The key benefits to investors from these products are:

  1. In an environment of rising interest rates, open-ended products are able to enhance yields by investing new inflows at higher rates.  This benefit is not available to investors in FMPs.
  2. If the fund manager holds a short average maturity, he not only reinvests are higher yields, but also moderates NAV volatility from rising rates. Active management of the portfolio to deliver total return is not a benefit investors in bank deposits get.
  3. Higher rates available in the wholesale markets for certificates of deposits and commercial papers are not accessible to retail investors, who either get a regulated saving rate or lower retail deposit rate.
  4. Systematic Investment Plans are available making it possible to make regular investment of short term surpluses.  Many of these funds have capped the maximum investment by an investor, to keep the retail focus.

The caveats are:

  1. These funds come with an exit load for 1 or 2 year horizon.  Since they are being retailed, the load is necessary to pay for distribution.  Investors need to have a minimum holding period before buying.
  2. The expense ratio can be high at 1% to 1.5%. These funds have to generate adequate return to make them relatively attractive compared to a lower cost ultra-short term fund.
  3. If interest rates begin to drop, the fund’s return will have to come from capital gains to make up for lower reinvestment income. Fund managers will then enhance the average maturity to manage total return.  Investors who come in later may see a lower return than those buying into a high rate now.

The emergence of these short term retail debt funds represents a strategic asset allocation option to investors.  At this time there is also the tactical opportunity to benefit from heightened short term interest rates.  I wrote in January about the growing opportunity in the short term debt fund space.  The easing of liquidity over the next few quarters may reduce this tactical advantage.

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