Ultra-short, low, and short duration funds: Which one is the best for you?

Understand the difference between ultra-short, low, and short duration funds.

Ultra-short, low, and short duration funds Which one is the best for you

Debt funds offer several advantages and can help one's portfolio tremendously. The popularity of debt funds has been highlighted by the fact that inflows worth a whopping Rs 1.1 lakh crore were directed towards debt mutual funds in October 2020 alone. 

One can park money in debt funds for any duration. Investing in debt funds for short-term needs is the most judicious way to park your short-term funds. However, there are many options available in the market and they can be confusing if one does not know the differences. But all of them invest in debt and money market instruments.

There are three main short-term fund categories that most investors are interested in: ultra-short, low, and short duration funds.

Related: Puzzled about debt funds? Here are answers to six common questions

What are some key aspects of short-term funds?

  • Duration: In simple terms, duration refers to the average time that the papers in a fund’s portfolio take to mature. Ultra-short funds have a portfolio duration of 3-6 months. For low duration funds, it’s 6-12 months, and for short duration funds, it’s 1-3 years. As such, the higher the duration, the higher the interest rate risk. Short duration funds have a slightly higher interest rate risk as compared to low duration schemes.
  • Credit risk: Ultra-short duration and low duration funds are more suitable for lower credit risk. This is due to their shorter maturity profile. Short duration funds, on the other hand, can take higher credit risk as they have a longer maturity profile in their portfolio. Fund managers can take a calculated risk to try and generate extra returns. Short-term debt mutual funds focus on high credit quality exposure. This in turn reduces the exposure to risks.

What are the benefits of investing in short-term funds?

Investing in ultra-short, low, and short duration funds offer many benefits, such as the following:

1. High returns

Returns offered by ultra-short, low, and short duration funds are higher than other options existing in the market for similar time horizons. Short-term debt funds are one of the best instruments if you want higher returns than traditional instruments without exposure to the risks and volatility of the share market. As the fund values of short duration funds don’t change drastically due to fluctuations in market rates, they are able to offer steady returns through multiple cycles of interest rates.

Let's take a look at indicative returns offered by a basket of ultra-short, low, and short duration funds over a period of one year:

  • Ultra short-term debt funds: 3.67% to 7.12%
  • Low duration debt funds: 2.49% to 8.16%
  • Short-term debt funds: 5.6% to 10.66%

2. Flexibility

Short-term funds do not make you commit to any specific term. This makes them more flexible than fixed deposits. The amount can be withdrawn partially or fully at any time. You can even shift the money from debt fund to equity fund or any other scheme without any charges.

Related: How debt and equity-based mutual funds differ in risk

3. Tax benefits

Investing in these funds could enable you to earn capital gains which are taxable. The taxation rate depends on how long you remained invested in such a fund. This tenure is known as holding period.

If the holding period is less than three years, the capital gains made within this period would be called short term capital gains (STCG). STCG is added to the investor's income and charged as per the investor's income tax slab.

However, if the holding period is more than three years, the capital gains earned during this period is called long term capital gains (LTCG). LTCG is taxed at 10% without the benefit of indexation and at the rate of 20% after indexation.

 Which is the most suitable for your portfolio?

You can choose between ultra-short, low, and short duration funds based on one main factor, which is the investment time horizon. Ultra-short duration and low duration funds are used for short-term investments, which are due in more than a few months. Short duration funds are suitable for medium- to long-term portfolios. It is not advisable to invest in short-term duration if you intend to withdraw your funds in a few months or a year. You can even hold a combination of ultra-short, low, and short duration funds to maintain a well-diversified debt fund portfolio.

Last words

We have seen that ultra-short, low, and short duration funds invest in pure debt and money market securities for short durations. They offer stable returns at a low risk. Such funds are most suitable for investors with a short horizon of a few months to a few years. If you are looking for stable income, flexible withdrawal options, and reasonable returns, consider adding these to your portfolio. 9 Financial products and their tax benefits




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