Short Term Mutual Funds: Meaning, Risks & Return

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Introduction

Investors often seek to invest their money in mutual funds as they are relatively safe security and can potentially draw in considerable returns. This article seeks to examine one particular kind of mutual fund, i.e., short-term mutual funds.

Defining Short-Term Mutual Funds

A short-term mutual fund can be categorised as an open-ended fund that has a maturity period that falls between 15 to 91 days. The time frame needed for this kind of mutual fund to achieve maturity varies and is dependent upon the maturity applicable to its underlying assets. Short-term mutual funds tend to primarily invest in high-quality assets that aren’t associated with several risks i.e., they are low-risk investments. Risk-averse investors are likely to appreciate short-term mutual funds the most. In fact, these mutual funds are a great place for those with surplus funds to invest. People who have longer investment timelines that extend between two to four months can invest in ultra-short-term funds.

Investors Most Suited to Short-Term Mutual Funds

Investors who are interested in an investment time frame that falls below three months are best suited to short-term mutual funds. In fact, for these time frames, these mutual funds are superior options to place money in comparison to regular savings accounts in banks. This is because they are able to generate greater returns in comparison to bank deposits and provide investors with a significant amount of liquidity.

Investors who have a low threshold for risk ought to consider investing in short-term mutual funds as they carry with them low levels of risk owing to the concise maturity time frames of their underlying assets. From a historical point of view, short-term mutual funds have generated returns that fell in the range of 6 to 8 per cent.

Taxes Applicable to Short-Term Mutual Funds (India)

Keeping in mind the amendments made to the 2020 Budget, dividends applicable to mutual funds are considered to contribute to overall income and are taxed keeping in mind the tax slab applicable to a given individual. Prior to the 2020 Budget being passed, dividends were considered to be tax-free in the hands of investors owing to the fact that fund houses were responsible for paying DDT (or dividend distribution tax) prior to paying dividends to their investors.

The rate of taxation on capital gains drawn from short-term mutual funds has the same rules apply to them as taxation applicable to debt funds. On the other hand, long-term capital gains, which pertain to the sale of debt fund units following a holding period that amounts to three years or more, have a taxation rate of 20 percent applicable to them following indexation.

Risks Associated with Short-Term Mutual Funds

Owing to the fact that short-term mutual funds are categorized as a form of debt funds, they carry with them almost the same risks associated with other kinds of debt funds. The risks associated with these funds – including some of the best short-term mutual funds in India – can be classified as follows.

Liquidity Risk

This risk refers to the possibility of the fund manager not being able to sell the underlying assets without incurring a pronounced loss.

Credit Risk

Credit risk refers to the possibility of issuers of underlying assets not abiding by their agreement to pay the regular interest along with the principal once the asset in question acquires maturity.

Interest Rate Risk

This risk is tethered to the interest offered by those who issue underlying securities. This interest rate may fluctuate owing to varied geopolitical and economic factors which can adversely affect the short-term mutual fund.

Potential Returns Drawn from Short-Term Mutual Funds

Certain short-term mutual funds available in India provide higher returns on investments in comparison to bank deposits. The rate of return applicable here can fall between 8 to 9 percent keeping in mind the assets in the fund portfolio under consideration. Next, in terms of the tax benefits, returns drawn from short-term mutual funds tend to exceed post-tax returns drawn from alternative investments.

Advantages Associated with Short-Term Mutual Funds

Short-term mutual funds bring with them the following advantages.

  • Short-term mutual funds make for great short-term investments.
  • They have the potential to generate more significant returns in comparison to ordinary savings accounts in a bank.
  • The risks tethered to short-term mutual funds are fairly low owing to the fact that their underlying assets mature over short time frames.
  • Investors who choose to invest in short-term mutual funds benefit from being exposed to a diversified portfolio that is made up of several different debts and money market securities.

Conclusion

Short-term mutual funds are classified as open-ended funds that function in a manner similar to other debt funds. They are characterized by having an investment objective that focuses on income generation via accrual over the course of a limited time frame that is needed for the maturity of the underlying assets that the fund invests in.