How to Choose Liquid Funds

The recent events around IL&FS’ debt paper downgrades have raised concerns about how safe even short-term debt funds like liquid funds are, for retail investors. Should you fear these or with some careful judgment can you minimize your chances of risks in this category? This article helps you with some simple tips to choose liquid funds and use them as a stable portfolio diversifier.

The recent scare

A few liquid funds from the Principal, LIC, and Union houses came under the radar for a hit to their NAVs because of providing for mark-to-market losses on their holdings in IL&FS and its group companies. There were funds from other categories too, holdings papers from the said group. However, a hit to the NAV of a liquid fund, considered the least risky, most liquid, and meant for the short term, has raised questions on how investors should approach this category. Before we move on to how you can choose liquid funds, it is important to know that the present risk that has surfaced is not an all-pervasive one in the liquid category.

For example, barring one fund, the entire universe did not hold short-term papers below A1+ as of August 2018. The average holding in instruments below AAA was a mere 0.7% and that too was held by a handful of funds. Hence, that liquid funds knowingly go for high-risk papers is not an easily acceptable argument. The outlier cases like IL&FS where a downgrade happened from top rating will of course be hard to identify but rare to occur in this category.

With that aside, how can you choose funds to reduce the risk of holding a fund that will take a NAV hit?

Don’t go merely by chart toppers: In the liquid space, it is very hard for funds to generate returns that are significantly different from peers unless they take marginal risks. Such risk would primarily come from the commercial paper space.

For example, Principal Cash Management, which was among the top performers until the recent hit, still has the highest yield to maturity in the category (as of August 2018) at 7.56%; higher than the category average of 7.08%. Hence, do not get lured by the topper in this space. You are better off with funds slightly lower in rank provided they fulfill the other criterion we mention below.

Fund ratings need to be viewed with caution: Ratings of liquid funds by various online websites are mostly influenced by returns alone and do not adequately consider risk or diversification. As a result, going by ratings alone may not be a prudent idea in this category.

At FundsIndia, while our ratings are not merely based on returns, there may be funds with higher ratings that we would not recommend if we have concerns with the size of the fund house or their strategies. These, would not be captured in a quantitative rating methodology. Hence, if a fund has above-average category returns and fulfills our other criterion here, you should prefer it even if it is not a 5-star rated fund.

Fund houses: While we are fans of smaller fund houses and their unique strategies when it comes to liquid funds, we prefer known names. Such fund houses attract treasury money from very large corporate houses and hence have a heightened onus to keep risks at bay and follow enough due diligence. This helps pin more responsibility on the fund manager and in the process, your money to has a better chance of being safe.

Size matters in liquid funds: Liquid funds are predominantly used by institutional investors for their treasury needs. When the AUM of a fund is small, redemptions by institutions with large exposure can impact returns. Hence funds with tens of thousands of crores are a blessing, not a threat when it comes to this category.

Look for diversification: Instances of top-rated (A1+) papers being downgraded to A4 are hard to predict nor can funds with such holdings be avoided. However, what you can do is check the concentration/diversification of a fund in the underlying instruments. For example, Axis Liquid has 134 securities in its portfolio. As a result, its exposure to individual securities (barring treasury bills) is low. Hence, even if one of its commercial papers is hit, the impact on NAV will not be high. On the other hand, Principal Cash Management, with just 20 securities, has concentrated exposure to the individual instruments and hence any hit also causes more pain.

Instruments to look for: Needless to say, treasury bills are the safest, but a fund cannot load itself only with treasury bills as its supply is not infinite. Hence, funds supplement their portfolios with certificates of deposits (CD), commercial papers (CP), and some NCDs which are nearing maturity. Note that liquid funds cannot hold a portfolio with an average maturity of over 90 days.

Hence, there is no duration risk in this category. What you would need to look for is a healthy dose of treasury bills (liquid funds on average held about 13% in treasury bills) and the rest mostly in CDs and CPs. Concentrated exposure in CPs (over 5%) is something to look for in terms of identifying risks, especially if such CPs are top holdings and are from lesser-known companies.

While using the above criteria will not entirely insulate you from NAV shocks, it will certainly reduce your chances. We use these besides established quantitative metrics by providing appropriate weights to them. This helps identify the low-risk, optimal return options.

Funds to invest

Here are some funds that will fit the above criteria quite well and in addition show the least instances of negative returns when returns are rolled weekly over the past 10 years (or since inception). They have also never had negative returns when returns were rolled fortnightly. In other words, over 2-week periods, these funds did not deliver any negative returns in the past decade.

Please note that you can use these funds for all the regular purposes of a liquid fund – short-term parking, systematic withdrawal, or even as a diversifier to your equity portfolio. Where you are doing STPs, you will have to stick to liquid funds in the respective fund houses. In such an event, your objective should be to choose a good equity fund rather than focus on the temporarily held liquid fund.

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.