How to evaluate liquid funds during crisis times

If you want higher than (bank) savings account returns with a little bit of risk, liquid mutual funds are your best bet. We tell you how to evaluate liquid funds

Kumar Shankar Roy May 13, 2020

Liquid fundsFor retail investors, the safest debt fund category is liquid funds. We at RupeeIQ have maintained this unpopular line for quite some time now. If you want higher than (bank) savings account returns with a little bit of risk, liquid mutual funds are your best bet. These funds can be tax-efficient too if you sell them after three years.

Liquid MFs allow you to park money for short periods of time. In the recent past, multiple debt fund investment related issues and the debt fund fiasco at Franklin Templeton have left a bad taste in everyone’s mouth. At this juncture, it is all the more important to understand the advantages liquid funds provide.

Past returns indicate nothing much for a new investor. The moment of truth is when an investor has to choose which liquid fund to buy. How to evaluate a liquid fund? Is the best-performing liquid fund actually the best one for me? What should I know about the portfolio of a liquid fund before I buy? Through this article, RupeeIQ tries to answer all these questions and more.

Safety first, returns last

Did you ever think the worst performing debt fund would actually deliver lower returns than the worst performing equity fund? If your answer is NO, you simply need to check the 1-year return of the worst debt fund (that is -72%) and compare it to the 1-year return of the worst equity fund (-60%). Today, an investor in debt funds realises that return of capital is more important than return on capital. Hence, safety is of paramount importance.

Liquid funds have been designed not to take too much of risk. But liquid funds use a variety of things to give the ‘liquidity’ to you. The average credit quality ranges from GOI/CASH to AAA. The average maturity ranges from 0.01 years to 0.18 years. But dont settle for these averages! A Do-It-Yourself (DIY) investor must dig deep.

Liquid funds that pre-dominantly invest in Government Securities, Treasury Bills and money market instruments issued by Public Sector Undertakings will deliver lower returns. So, one should moderate return expectations and heighten safety expectations in such liquid funds.

Take a look at some liquid funds to understand this. As on 17 April, the entire corpus of HDFC Liquid Fund was invested in A1+ & equivalent securities and treasury bills, thereby ensuring higher liquidity. As a consequence, the portfolio YTM (Yield To Maturity is not expected return!) of the fund stood at 4.44% on that date. Do remember that YTM or Yield to maturity is the total return anticipated on a portfolio if it is held until it matures. Yield to maturity is considered a long-term portfolio yield but it is expressed as an annual rate.

For IDFC Cash Fund, 8.56% of corpus is invested in A1+ rated Certificates of Deposit, 33.92% in A1+ rated Commercial Papers, AAA rated Corporate Bond 29.12%, Treasury Bills 22.59% and 4.02% in zero coupon bonds. This highest rated investment approach means that YTM is 4.38% as on April 30.

For Quant Liquid Fund, which sports the highest NAV-based return of 6.34% in last 1 year period, the entire corpus as on April 30 was invested in only 5 debt securities: A1+ commercial papers and A1+ certificate of deposit. The current portfolio YTM at 6.7% is much higher but that comes with some additional risk as well.

Additional Read: SEBI nod for day-wise exit load structure for liquid fund investors redeeming within 7 days

Study portfolio properly

Liquid funds cannot invest in any paper that has a maturity more than 91 days. This is why you will not be stuck in long-dated debt. Most of the liquid fund portfolios are naturally focussed around money market instruments.

But, remember that liquid funds can allocate small parts of their portfolio to bonds, which may have ratings lower than AAA. Such bonds will mature in a few weeks or a couple of months. Do note that ratings are not cast in stone. In the uncertain economic background that we are currently living in, many companies may suffer rating downgrades. These ratings may be top-notch today, but they may go down soon. In early May, rating agency ICRA downgraded the ratings of instruments of Edelweiss group companies.

As a liquid fund investor, take cognizance of such non-government papers. Do check for the strength of underlying companies. Not every paper that is AA or below is bad or risky. If you are not comfortable with any risk, go for the safest debt funds and sacrifice any extra return hopes.

On the other hand, if you are okay with extra risk for extra returns (or losses), then you can try some liquid funds that are more creative. Any extra return compared to peers in liquid funds comes from taking more risk. Take a look at Franklin Liquid Fund, the second best performer in 1 year period with 6.3% gain versus category average of 5.6%. The fund has exposure to AA- rated Tata Motors, which accounts for about 3% of its assets. This is the highest exposure for any liquid fund as far as AA- rated Tata Motors debt is concerned.

Credit risk assessment is crucial in liquid funds. Don’t panic if a small proportion is in an AA-rated paper for a very short period. That is probably okay unless it is a terrible company, or a stroke of sheer bad luck!

Additional Read: Arbitrage funds pitched as better alternative as liquid fund returns slow down

Go for diversified portfolios, not just size

Prefer a liquid fund with a diversified portfolio. Too few debt securities in a portfolio is a concentration risk red-flag. Avoid buying funds with 8-10 debt securities if they are from private sector companies only. The basic rule of diversification says that one should spread out the risk across securities. Any liquid fund portfolio that is earning its money from a handful of non-government securities is exposing your money to concentration risk.

A liquid fund should ideally have 25-30 securities from different companies. Of course, the larger a fund and the greater number of debt security types it plays with, the ultimate number of debt papers rises. But not all smaller liquid funds have a few number of securities. For example, the less than Rs 600-crore PGIM India Insta Cash Fund has 22 debt securities.

Liquid funds as a category have an average 48 securities. What we are talking about is much lower number and that too in the context of non-sovereign debt. Remember that a low number of securities does not necessarily mean that the fund is bad, it merely means it has high concentration risk. For instance, Essel Liquid Fund and Yes Liquid Fund have five securities each. But if these securities are treasury bills and PSU debt papers, there is almost nil credit risk even though the total number of securities is low. The Quant Liquid Fund also has five securities, but all of them are debt papers of private sector companies/banks, which makes it risky from a concentration point of view..

Also, remember that blindly selecting the largest fund in liquid fund category is no passport for safety. Various instances have shown that even large debt funds (of non-liquid categories) can pose problems. Do not assume more safety in a giant sized fund. Of course, a large liquid fund indicates two things. One, many investors have reposed their faith in the fund which caused it to be big. Two, many investors have found the fund performing as per their expectations which has led to them allocating money to the fund. The five biggest liquid funds are HDFC Liquid (Rs 87,870 crore), SBI Liquid (Rs 51,614 crore), ICICI Pru Liquid (Rs 45,457 crore), ABSL Liquid (Rs 33,418 crore) and Kotak Liquid (Rs 27,398 crore).

And another consideration investors should look at is how strong is the sponsoring asset management company (AMC). How big is their balance sheet. And how they have behaved during crisis in the past. This matters when a large crisis like coronavirus hits the economy. We would prefer AMCs who can absorb big shocks, manage redemption pressures, and do not leave their investors in lurch. We have seen recently how an AMC shut down six debt funds, blaming the situation on coronavirus. Strangely, other AMCs have not taken this action while they also operate in the same environment. We have also seen how HDFC AMC bought out troubled securities from one of their debt funds thus protecting the investors from the papers that have gone wrong.

So do your due diligence on the AMC as well.

Additional Read: Edgy about debt funds? Here are two low risk categories of debt mutual funds


Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at kumarsroy@rupeeiq.com.

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