Ultra-short-term (UST) funds invest in short-term securities. They are not as liquid as a liquid fund or a liquid-plus fund and the average maturity is slightly longer. The best way is to understand UST funds is that they are different from liquid funds and short-term funds.
Liquid funds, short-term funds and ultra-short-term (UST) funds
Liquid funds are at the lowest end of the duration spectrum. They invest in very short-term debt instruments with a maturity period of 15 days to 91 days. They are virtually free of any kind of interest rate risk or market risk. Liquid funds typically invest in call money, commercial papers, certificates of deposits, Treasury bills etc.
Short-term funds, meanwhile, invest in debt instruments with a residual term to maturity of 1-3 years, and hence, they carry relatively higher risk and returns.
Falling in between liquid funds and short-term funds, you have the UST funds. While liquid funds invest in bonds with a residual maturity of 15-91 days, UST funds invest in bonds with a residual maturity of 91 days to 365 days. The UST fund is marginally higher on the risk and return scale compared to the liquid funds, but is below the short-term funds.
UST funds are good to part your short-term monies but not exactly liquid
Liquid funds are good to park very short-term monies needed for salaries, advance tax, GST etc. Monies that you do not require for a period ranging from 3 months to 12 months can be parked in UST funds. You can distribute investments accordingly. These are quarterly payments or six monthly payments where the outflow is certain but you have time on hand. Such monies can be invested in UST funds so that you can earn slightly higher returns without taking on too much additional risk.
Very low total expense ratio (TER) is a major advantage of UST funds
The total expense ratio (TER), in the case, of UST funds is higher compared to the liquid funds. One of the basic reasons for higher costs in UST funds is that liquid funds are not required to mark most of their holdings to market (MTM), whereas UST funds are required to provide MTM on a daily basis. However, UST funds, being invested in instruments of less than a year’s duration, have very low levels of price risk.
Then there is the added challenge of exit loads.
Liquid funds do not attract exit loads. UST funds, however, charge exit loads but the total expense ratio (TER) and the exit loads on a UST fund is much lower than short-term funds. This makes moving in and out of UST funds quite easy and does not entail too much of a cost.
Where do UST funds actually fit in?
Ultra-short-term funds have a much broader range and invest from 7 days to up to 18 months at times, although the preferred time frame is up to 12 months only. UST funds will be better for investors who want to park their monies for a period of 1 to 9 months. Since the debt profile of UST funds is longer than liquid funds, there is an element of interest rate risk in UST funds, whereas it is negligible in the case of liquid funds. In normal markets, this is fine. When interest rates become volatile, like in the current scenario, UST funds could be volatile compared to liquid funds.
Some additional risks in UST funds
There is a lot of leeway for the fund manager in structuring the portfolio of the UST fund. As a result, some discretion may creep into a UST fund and that is a discretion risk. UST fund managers actively manage maturities based on their interest rate and liquidity outlook. For example, UST funds typically oscillate their assets from a few days to a few months. There is also the risk of UST fund managers trying to search for higher returns by going down the credit quality curve. This may give higher returns but also comes at a higher risk. UST fund managers also create alpha by taking a view on interest rates. They work maturities accordingly and this adds an element of discretion to the UST fund.
Combining UST funds can add more value
Firstly, UST funds can be combined with liquid funds to add more value to your emergency funds. Secondly, if you compare with 3-6 month bank deposits, UST funds can be more productive. Lastly, when you do STPs or SWPs, the return on the debt fund also matters. Here, you can replace the liquid fund with UST funds to add to your eventual portfolio return, which can be better even if you add the higher TER and the exit load, if any.