Should you invest in ultra short duration funds for extra returns?

Many mutual fund investors are confused about whether to park their short-term money in liquid funds or ultra short duration funds. They believe that since the two categories are ‘almost’ similar and have very low risk, they can opt for ultra short duration scheme to earn extra returns. Is it a good idea?

To begin with, ultra short-duration schemes are debt mutual fund schemes which invest in fixed-income instruments of maturities up to six months. According to the recent Sebi definition, ultra short duration schemes are open–ended debt schemes investing in instruments with macaulay duration between three months and six months.

Ultra short duration funds are almost similar to liquid funds in terms of liquidity and returns.Generally, the investment horizon for ultra short-duration funds ranges from a week to 18 months. Investors, who want to park their money for a month to six months, can choose the ultra short duration category, say mutual fund advisors. These schemes are essentially duration schemes and are impacted by the interest rate scenario. However, they are the least impacted among the duration fund category. Easing rates are a good news for these schemes. Ultra short-duration funds category has given 6.12 per cent returns in the last one year.

While most investors use liquid schemes to stagger their investment via STP, many mutual fund advisors believe that ultra-short duration funds can also be a good option to start an STP. They believe that investors can stagger their investment and also enjoy extra returns in ultra short duration schemes. “Ultra short duration schemes are the best choice for conservative debt investors who want to take advantage of the rate changes and low yields. This is the safest instrument to play the duration because of the very short maturity of the underlying investments,” says Deepali Sen, Founder, Srujan Financial Advisors.

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While these schemes are not impacted by the interest rate changes very much, there can be a case of credit risk. That makes ultra short duration schemes riskier than liquid funds. “Higher the duration of the securities, higher the risk in the schemes,” says Pankaj Gera, a certified financial planner. However, these schemes also have the potential to offer higher returns to compensate for the extra risk.

Mutual fund advisors believe that investors can expect returns of around 7-9 per cent from these schemes. However, they reiterate that investors should remember that the returns are not guaranteed like bank fixed deposits. These schemes might generate higher or lower returns based on the market scenario. If the interest rates rise, the net asset values (NAVs) of these schemes might see a dip.

“Ultra short duration funds are ideal for investors who have a short-term goal, with a time horizon of 6 to 12 months, and can handle some volatility for a bit of higher returns. For investors with very short term parking needs with least amount of risk, overnight funds are better suited,” says Shifali Satsangee, Founder, Funds Veéda.

These schemes are similar to other debt funds in terms of taxation. Just like other debt mutual funds, ultra short duration schemes held for more than three years are eligible for long term capital gains tax of 20 per cent with indexation. If sold before three years, you have to pay tax on gains as per your income tax slab. The fund will be subject to a dividend distribution tax of 29.12% if you opt for the dividend option.

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