Best Short-Term Mutual Funds in 2022

Who Should Invest Short Term Mutual Funds?

Short-term mutual funds are suitable for those investors having an investment horizon of shorter than three months. These funds are a better option than a regular savings bank to park your surplus funds. Short-term funds are capable of providing much higher returns than bank deposits and provide much-needed liquidity.

Risk-averse investors may consider investing in these funds since the risk carried by these funds is on the lower side due to the shorter maturity period of the underlying securities. These funds have historically provided returns in the range of 6-8%.

Taxability of Short-Term Mutual Funds

As per the amendments of the Budget 2020, dividends offered by all mutual funds are added to your overall income and taxed as per the income tax slab you fall under. Before the Budget 2020, dividends were made tax-free in the hands of investors as the fund houses paid dividend distribution tax (DDT) before they paid out dividends to the investors.

The rate of taxation of capital gains of these funds follows the rules of taxation of debt funds. Short-term capital gains (realised on selling your debt fund units within a holding period of three years) are added to your overall income and taxed as per your income tax slab. Long-term capital gains (realised on selling your debt fund units after a holding period of three years) are taxed at a rate of 20% after indexation.

Risks Possessed by Short-Term Funds

Since short-term funds are a class of debt funds, they nearly carry the same risks that any other debt funds carry. Short-term funds come attached with the following risks:

• Liquidity Risk

Liquidity risk is the possibility of the fund manager being unable to sell the underlying instruments without resulting in a significant loss.

• Credit Risk

This is the possibility of the issuers of the underlying securities notwithstanding by their word of paying regular interest and principal at the time of maturity.

• Interest Rate Risk

This is the probability of the interest offered by the issuers of the underlying securities fluctuating due to the various economic and geopolitical factors.

What is the Return Potential of Best Short-Term Mutual funds?

Some short-term mutual funds in India offer comparatively higher returns on investment as against bank deposits. The return rate could range between 8-9%, again, based on the assets in the fund portfolio. Considering the tax benefits, the return on these investments tends to be higher than the post-tax returns from other forms of investments.

Advantages of Short-Term Funds

The following are the most significant advantages of investing in short-term funds:

• These funds are an excellent short-term investment option.
• Short-term funds have the potential to provide much higher returns than a regular savings bank account.
• The risk possessed by these funds is on the lower side as the underlying securities mature over a short period.
• The investors of these funds get exposure to a diversified portfolio constituted by various debt and money market securities.

How do Short Duration Funds Work?

In order to get a clear understanding of how short term mutual funds work, you need to have a clear idea of the concept of duration. It will also help you understand how it impacts the scheme’s investment decisions and returns.

• Duration

A mutual fund’s duration represents its interest rate risk. The extent to which a fund’s value changes in response to the fluctuation in market interest rates is measured by its duration. The longer the fund’s duration, its value will become more volatile, and the interest rate risk will also increase. Experts calculate duration using a complex formula. 
However, retail investors should remember that a debt fund’s duration has a close link to the maturity of bonds in its portfolio. The schemes that have invested in long-maturity bonds will have higher durations in comparison to mutual funds that are mainly holding short-term securities.

• Short Duration

Short duration funds generally have a duration of one to three years. These schemes can invest in both short term and slightly long-term debt securities. When it comes to interest rate risk, short duration mutual funds are present at the lower end of the spectrum. 
However, they are higher than ultra-short duration and liquid funds but lower than long and medium duration schemes.

• Investment portfolio of short duration mutual funds

The investment portfolio of short duration funds consists of government securities, corporate bonds, derivatives, and securitised debt. They also contain bonds issued by public sector corporations and financial institutions. In addition, they also hold TREPs, T-bills, certificates of deposits or commercial papers in order to maintain liquidity. 
As short duration mutual fund schemes have no credit quality norms, they also have the option to put their money in low-rated debt instruments to reap higher returns. Although, the ongoing credit/market conditions and the fund’s investment pattern will dictate how much they will expose themselves to lower quality debt.

• Earning Sources

Both interest and capital gains serve as earnings for short duration mutual funds. Income from interest is generated from interest payments on these schemes’ debt holdings. They also actively manage their fund durations in order to reap the benefit of changing interest rates. 
As the market interest rates fall, the value of the fund’s securities rises and results in capital gains. However, when the interest rates fall, the fund scheme makes capital losses. Thus, you can say that the mutual fund’s duration and market interest rates at that point in time determine its extent of capital gains and losses. 
Short duration mutual funds having a duration at the lower end of the one to three years range have a low chance of making any capital gains or losses.

Frequently Asked Questions

1. How long should an individual invest in short duration mutual funds?

An individual should invest in short duration mutual funds for at least one to one and half years.

2. Are short duration mutual fund investments risky?

Short duration mutual funds experience volatility. However, if you invest in them for at least one to two years, the risks are comparatively less.

3. Can individuals invest in short term funds using SIPs?

Yes, individuals can invest in short term funds using SIPs.

4. Do short term mutual funds have an expense ratio?

Yes, short term mutual funds have an expense ratio. The fund managers charge you on the ratio of gains and returns on your investment.