Ultra Short Duration Funds

What Are Ultra Short-Term Funds?

Ultra short term funds are mutual funds that invest in securities and instruments belonging to the fixed-income earning category, with maturities of up to six months. They are close to liquid funds as they offer more liquidity than any other fund category with long term investments.

As per SEBI guidelines for liquid funds, such funds cannot invest in securities that mature beyond 91 days. But these rules do not apply to ultra short term funds. These funds can invest in funds that mature before or after 91 days. The horizon for these funds ranges from a week to 18 months.

Who Should Invest in Ultra Short-Term Funds?

Ultra short term funds are fixed income mutual fund schemes that invest in debt and money market securities. They are less volatile and produce more stable income in comparison to longer duration investments. Ultra short duration fund is best suited for those having surplus funds to park for 1-9 months and earn dividends on them.

These funds are subject to both credit risk as well as interest rate risk, and hence they can be a good choice for investors who understand this kind of risk level.
Conservative investors who can remain invested for a period ranging between 3 months to 1 year should go in for these investments.

According to experts, ultra short term funds can be used by investors for both short term investments as well as for systematic transfer plans (STPs). For example, suppose a person intends to invest in equity funds instead of putting all their funds in a one-time lump sum fund. In that case, they may invest it in an ultra short term fund belonging to the same fund house and later instruct your fund manager to switch a regular amount to your equity fund every month.

It should be noted that these funds do not generate assured returns or capital safety. However, if you hold funds for more than three months, then the possibility of incurring losses is much lower.

Taxability of Ultra Short Term Funds

Having low maturities, the returns from ultra short term funds are predictable. The return is calculated on the rise and fall of the NAV. Gains from ultra short term mutual funds are taxable. The duration of the investment determines the tax ratio.

When investments are for less than three years maturity duration, they come under the short term capital gains category (STCG). A tax amount is charged by adding the amount of the return to your total income and then taxed as per your income tax slab rate.

On the other hand, investments with a holding period of more than three years fall under the long term capital gains (LTCG) category. They are then taxed at a rate of 20% with indexation benefit and 10% without indexation benefit.

Since gains from ultra short term funds fall under the first category of STCG, they are taxed accordingly.

Risks Involved With Ultra Short Term Funds

Even with the best ultra short term funds, there are certain risks involved, despite having a lower interest rate risk owing to their short maturity. They carry the same category of risks, just like any other mutual fund.

Credit risk- The fund manager’s investment strategy might have low credit quality securities, expecting to upgrade them in the future. This risk of default by the issuer of the underlying securities exposes the fund to credit risk.

Interest rate risk- There is always a risk pertaining to the increase and decrease in the interest rates on the value of the fund, even though the returns on ultra short term funds are more or less predictable owing to their short maturity duration.

Liquidity risk- This risk may arise due to the fund house’s inability of not having sufficient liquid funds to meet their redemption requests.

Hence, to minimize the above risks involved with ultra short term funds, it is important to research about the portfolio fund and ensure that investments are done in high rated securities.

Further, you need to make sure that the fund manager/ fund house has relevant experience in managing investments and switching interest rate regimes amidst rising and falling markets so that your fund performs optimally.

Advantage of Ultra Short Term Mutual Funds

Ultra short term funds invest in very short term debt funds and are practically free of any kind of market risk or interest rate risk.

There are several advantages of investing in ultra short fund portfolios which can be listed as under:

Good to park your short-term money- Any surplus money which you do not require for a period of 3 to 6 months can be parked in the ultra short term funds. You can opt for quarterly or six monthly payments, and thus make a little higher returns on your investments without taking too many additional risks.

Very low total expense ratio (TER)- These funds are required to provide MTM daily basis. However, being invested for less than a year, these funds have very low price risk levels. Also, even though these funds charge exit loads, the exit ratio is much lower than short term funds.