FundsIndia Views: Why you need help choosing debt funds

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Most of you look at returns of equity mutual funds to pick a fund to invest. When the same yardsticks are applied to debt funds, they can be misleading, if not disastrous. Why? Because there is a high chance of your choosing the wrong fund which does not fit your requirement.

This can be due to several reasons: names of these funds can be misleading, the categories that they really belong to can be different, and above all, the strategy they adopt even within a category may have varying degrees of risk. All these can have an impact on whether your capital swings or remains steady, whether there may be short-term losses that resolve over the longer term, whether there are chances of significant longer-term hits on the NAV, and what your eventual returns are likely to be. When you invest in a debt fund, you have none of these risks in mind. Most of you simply view it as a superior earning option to FD.

Why are we talking about these complexities now? SEBI’s recent proposal of consolidating and categorising mutual funds brings into question whether the inherent complexities of debt funds, coupled with the compulsive behaviour of some funds to chase returns by changing strategies can be addressed at all.

In this article, we enumerate the reasons why choosing a debt fund is not an easy job and why you need guidance in this space more than you need in equity.

It’s not in the name

In the Indian context, at least, knowing the name of a fund may not tell you much about where it invests. For example – ICICI Pru Ultra Short-Term Plan might have a clear ‘ultra short-term’ tag in its name, but, sports a different profile. With an average maturity of over 2.5 years and AAA-bonds and medium to long-term state development loans, it is not much of an ultra-short-term debt fund in terms of risk and tenure. Because of this, its returns may also seem significantly higher than funds in the ‘ultra short-term’ category given its strategy. At present, it is a short-term debt fund and requires a 2-year time frame at least. If you invested in it for 3 months, you enhance your risk.

There are many such funds where names can be misleading. Birla Sun life Treasury Optimizer might seem like a liquid treasury fund but sports a profile of a short-term debt fund.  ICICI Pru Income follows a duration strategy although its name might suggest it has an accrual strategy. Hence, its returns can swing more than an income fund.  Misreading tenure and risk profile based on a fund’s name can hurt your returns.

Different categories, different behaviour

Different categories of funds sport different behaviour. A typical query from some of you and our advisors’ response to it is as follows:

You: ‘X’ fund has higher returns than ‘Y’ fund. Why are you giving me X? Also, my bank relationship manager was suggesting X fund to me last week”.

Advisor: “Y fund is a liquid fund (or an ultra-short-term fund) and X fund is a long-term dynamic bond fund. Since you need the money in the next few months, we cannot give you high-risk funds. X fund can deliver negative returns even over 1-3-month time frames. They don’t fit your requirement”.

Here’s a fact: close to 50% of the funds we rate under the dynamic bond fund category and a third of them in the long-term gilt category have had negative 1-year returns at some point (even if briefly) in the last 3 years. Imagine the risk of holding these for your short-term needs simply based on high past returns. When we sift through funds, we not only avoid such funds in the long-term category (by using quantitative filters that ensure high risk is penalised) but also specifically make sure that investors do not choose them for short-term needs.

That is just one part of the problem. The bigger problem is funds changing colour – changing strategies so much so that their category itself may have to be reviewed. Let us take an example of a fund like L&T India Short Term Income fund. Five years ago, this fund had 30% in commercial papers/CDs and 40-50% in AAA-rated bonds. Today, it has no commercial papers, just 5% in AAA-rated securities and close to 70% in AA and AA- papers. And now, in spite of its name, it is classified as a credit opportunity fund by us, from earlier being a short-term debt fund. The fund’s risk calls for a higher holding period and we would be unable to offer it under a short-term banner.

Broadly, some funds in the short-term, income and credit opportunity categories tend to move between categories as they do not follow a single dedicated strategy and shift where returns are visible. In rare cases, even ultra short-term debt funds change categories. Also, sometimes some categories may mimic others. For example, post rate-cut rate scenario, dynamic bond funds may seem like income accrual funds.

All this means that when you bought a fund, its profile may have been different and 5 years hence, they may be altogether different one. When we provide you with investment-worthy funds, we try to, as far as possible, pick funds that are not only good performers but have stuck to their strategy across several market phases.

Different risk profile within the same category

There could be varying styles and varying risk profiles even within a fund category. For example, in the ultra-short-term debt category, a fund such as BOI Axa Treasury Advantage has a far higher 1-year return than ICICI Pru Flexible Income Plan or UTI Treasury Advantage. The former has twice the proportion of holding in instruments less than AAA-rating and naturally holds higher yield to maturity. In other words, the higher returns have come with enhanced risk. Higher risk has translated into more occasions of 1-month negative returns for the BOI fund compared with the other two.

For many of you, when negative returns even in long-term debt funds like dynamic bond funds are unacceptable, would you be able to deal with the risk with ultra-short-term funds? Also, remember some of the NAV write-offs in case of defaults have been more impactful in the ultra-short-term and short-term debt categories than longer term debt.

In categories such as credit opportunity funds, there is a significant variation in the proportion of papers with a rating below AA+. It can range from 45% to 89%! Taking these on a standalone basis alone won’t help decide your choice of fund. Whether the risk delivers adequately with limited volatility needs to be assessed.

Similarly, even within the dynamic bond category, based on the maturity of the fund portfolios the returns, as well as interim falls, can vary a lot. The question here again is to choose funds that swing less.

Summary

In our view, while a debt fund can no doubt be a superior option to FD, it is not easy for you to pick one by choosing one or two criteria. It is best addressed by talking to your advisors. At FundsIndia’s Research Desk, we seek to constantly refine our methodology to ensure these quirks are properly addressed and normalised in our ratings. Do join us for a discussion on this subject on soon. We will keep you posted on the date and time.

FundsIndia’s Research team has, to the best of its ability, taken into account various factors – both quantitative measures and qualitative assessments, in an unbiased manner, while choosing the fund(s) mentioned above. However, they carry unknown risks and uncertainties linked to broad markets, as well as analysts’ expectations about future events. They should not, therefore, be the sole basis for investment decisions. To know how to read our weekly fund reviews, please click here.