How and why are low duration funds essential for your portfolio?

2017 witnessed a major event in the Indian mutual funds space. SEBI launched a re-categorization and rationalization exercise to ensure that mutual funds remain “true” to their label and schemes within the same category share uniform characteristics. For investors, this re-classification of debt funds, equity funds and hybrid funds would translate into simplicity and standardization. This in turn would enable them to pick the correct funds for themselves. 

This re-classification exercise had three major type of changes – a mere change in the name of funds, funds which have now moved into another category (resulting in a change in investment style) and funds which have merged with some other fund. 

As per the revised classification of debt funds, there are 16 types of schemes in this category. Broadly, there are two ways to look at this classification of debt funds – basis their duration or strategy. Duration wise they can be classified into overnight, liquid, low duration, short duration, ultra-short duration, medium, medium to long and long duration. In this article, we will talk about low duration funds and why they are essential for your portfolio.

Low Duration Fund Meaning

Low duration funds invest in debt and money market securities in such a way that the fund’s Macaulay duration is between six months to a year. The maturity period of these funds lies somewhere in between the new classification of debt funds. They have a higher maturity duration than overnight, liquid and ultra-short duration funds but shorter than short, medium, medium to long and long duration funds.

As per a report published by BloombergQuint, the AUM of low duration funds grew by 8% in the year 2019.

Why it is a good idea to invest in low duration funds? 

  1. Risk

Debt funds are known as the relatively less risky investment route. However, within debt funds too, the level of risk varies basis the maturity period. Risk and maturity period are directly related. Longer is the maturity period, higher is the risk (due to higher probability of interest rate fluctuations).

As a result, low duration funds are considered as a safer option amongst debt funds. Investors with a lower risk tolerance can easily invest in these funds. 

  1. Return

Low duration funds score not only on the risk parameter, but also returns. Compared to other (relatively less risky) investment options such as savings account, etc. these funds have the potential to generate higher returns.

  1. Supplementary income

These funds can be used as a way to generate a steady stream of income (mix of interest and capital gains). A SWP (Systematic Withdrawal Plan) can help you to fund your financial goals in the 6 to 12 months’ time frame.

Things to keep in mind while investing in low duration funds

  1. Investment Tenure
    Low duration funds can give you the optimum results provided your investment tenure does not exceed one year. It is important to align your investment horizon with the maturity period of the chosen debt fund
  2. Expense Ratio
    Considering that your investment is for a relatively short time frame, the expense ratio can play a crucial role in your net gains. A lower expense ratio will help in maximizing your returns. However, this should not be the only selection criterion. It needs to be assessed along with other quantitative (performance track-record, consistency, etc.) and qualitative (fund house reputation, track record of fund manager, etc.) factors.
  3. Risk
    Always remember that no investment avenue (even FDs) are devoid of risk. A low-duration fund definitely carries lesser risk. However, the word to be noted is “lesser”. Even these investments have three risk components – credit risk, liquidity risk and interest rate risk. You should be mindful of this fact.
  4. Portfolio composition
    It can happen that these funds lend their corpus to risky borrowers in order to enhance their returns. Hence, you need to examine the quality of funds comprising the portfolio. A high amount of low-quality debt is a red flag as a large default will plummet the fund’s value sharply, leaving no or minimal scope for recovery.

Final Verdict

Low duration funds can be a great addition to your portfolio. Now that you know everything about low duration fund meaning, suitability and benefits, why are you wasting your idle cash in bank accounts?  Remember every penny counts!

Published by Nidhi Mehra

I am blogger with 5 years of experience in writing articles and topics related to finance and funds

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