What are Short Duration Mutual Funds? How to Invest in Short Term Funds? (2024)

Short-duration funds are debt funds that invest in debt and money market securities such that the duration of the fund portfolio is between 1 to 3 years.

1. Better Tax-efficient returns than FDs

Short-duration funds are more tax-efficient than bank deposits because if the fund is redeemed after being held for more than 3 years, the benefit of indexation kicks in, and investors end up paying lower taxes (see the section on tax advantages for details).

2. Things to Consider Before Investing in Short-Duration Funds

Short-duration funds are the entry-point vehicle for investors who do not mind taking on some interest rate risk in exchange for higher returns. In general, these funds generate stable incomes in the short term. However, fund values can show a lot of volatility if there are unanticipated changes in interest rates. For example, suppose a rate cut is widely expected. Market rates will start declining, and fund managers will increase their holdings of long-term debt. Now, if the RBI unexpectedly pauses in its rate action (neither cuts nor raises rates), yields in the market will correct by rising up again. This will result in a fall in fund value, which will not be reversed until (i) rates decline again and/or (ii) fund value is restored by the accumulated interest income of the fund. Thus, investors must be aware that short-duration funds experience periodic episodes of volatility; and this must be factored into their investment decision.

Some short-duration funds may carry higher credit risk than others, which may expose the fund to the risk of default and possibly, loss of value. During the recent NBFC crisis, there were instances of value erosion among debt funds due to default on the part of bond issuers. Investors must keep in mind that returns on short-duration funds are not assured and that past performance is no guarantee for future returns.

3. How to find the best-performing short-duration fund

Short-duration funds can be evaluated on three main parameters- return, risk, and expenses. Each of these parameters is discussed below.

• Return:Short-duration funds are usually recommended for investors with a holding period of 1-3 years. Hence, in evaluating the performance of a short-duration fund, it is best to track its returns over a 1-year, 2-year, or 3-year period. A well-performing fund will earn higher returns than its benchmark and its peer funds on a consistent basis.
• Risk:To evaluate risk, a good starting point is to examine the portfolio details. Funds that hold a relatively larger part of their corpus in securities with a credit rating below AA carry higher default risk but may also earn higher returns. An investor who is not comfortable with the exposure to credit risk should opt for a short-duration fund that invests mainly in the highest quality bonds (AA or AAA) and generates slightly lower returns.
  The next step is to track interest rate risk by looking at the trends in fund duration. Short-duration funds that actively manage duration expose the investor to greater volatility in fund values, though they may deliver a few extra points of return for taking on additional interest rate risk. Investors must ensure that the fund volatility matches their risk tolerance. Finally, a qualitative assessment should be made based on the management philosophy of the fund manager and the attitude of the fund house towards risk management.
• Expense Ratio:Mutual funds charge an annual expense ratio for managing the fund portfolio. Higher expense ratios reduce investor returns because the final return to the investor is obtained after subtracting the expense ratio. Hence it is important for investors to keep track of expense ratios.

4. Top Short-Duration Funds

5. Summary

• Short-duration funds aredebt fundsthat invest in debt and money market securities such that the duration of the fund portfolio is between 1 and 3 years.
• Short-duration funds invest mainly in short-term securities, with a part of their corpus allotted to longer-term securities. The extent of exposure to long-maturity debt determines their interest rate risk.
• Short-duration funds invest in a wide range of debt and money market securities, with no SEBI-imposed restrictions on credit quality.
• Short-duration funds earn through interest income and capital gains on their debt holdings.
• Short-duration funds offer stable returns for moderate risk. Investors with moderate risk appetite can opt for these funds as an alternative to other short-term instruments.
• Short-duration funds are most suitable for investors with an investment horizon of 1-3 years, those looking for stable income, first-time investors in debt funds, and those with a moderate appetite for interest rate and credit risk.

6. Frequently Asked Questions (FAQs)