High interest rates and volatile equity markets make a good case for liquid and ultra short-term (ST) funds. Given that funds in both these categories are giving around 8.5-9.5% and are considered relatively less risky owing to the short maturity of the securities held by them, they are good instruments to park funds in the interim. But which should you choose—a liquid fund or an ultra ST fund?
Liquidity profile and risk
While liquid funds invest in securities with residual maturity up to 90 days, ultra ST funds can invest in securities with maturity higher than 90 days. At present, the average maturities for liquid funds are around 45-60 days; for ultra ST funds, they are about 150 days or lower.
At the time of purchasing liquid funds, if your funds are transferred before 2pm, you get the previous day’s net asset value (NAV), else the same day’s NAV. For ultra ST funds, there is no such provision; if you transfer funds before 3pm, you can get the same day’s NAV, else the next day’s NAV. At the time of redemption, the same day’s NAV is applicable if the funds (both liquid and ultra ST) are redeemed before 3pm; the redemption proceeds go to the investor the next day.
Liquid funds are generally considered less risky as compared with ultra ST funds on account of the fund duration being lower. Moreover, there is no mark-to-market requirement in liquid funds and NAV valuation is done on accrual basis by adding the coupon accrued for the day. For ultra ST funds, the portions of securities with a maturity above 90 days have to be marked to market. In other words, the change in their market price as a result of change in yield has to be recorded on a daily basis, which may cause additional volatility in NAVs. Generally, the marked-to-market portion of the portfolio in ultra ST funds is not high, thereby minimizing the impact of price change.
The tax implication makes ultra ST funds attractive. Liquid funds are subject to a dividend distribution tax of 25% (effective rate after surcharge and cess is 27.04%). For ultra ST funds, the tax is 12.5% for individual investors (effective rate 13.52%). The short-term capital gains tax (for growth units) in case of both is as per your income-tax bracket; long-term capital gains tax is at 20% with indexation.
Liquids funds usually don’t have an exit load. Ultra ST funds charge exit load in the range of 0.1-1% if funds are redeemed before a specified time period, in the range of one week to six months. The exit load helps ultra ST funds maintain stability and manage fund outflows better. This is beneficial for small investors and reduces NAV volatility.
What should you do?
While liquid funds score better on liquidity, ultra ST funds give better returns. Currently, the category average pre-tax annualized return for ultra ST funds is around 9.5% and for liquid funds 8.25%. Remember to check the exit load and the credit quality of the portfolios.