Is my liquid mutual fund safe?!

Published: February 24, 2017 at 12:15 pm

Last Updated on

The incredulous 7% fall in the NAV of Taurus Liquid Fund due to a credit rating downgrade has many worried.  Can investors avoid such funds? Is this a “small amc” problem? Is this a small aum problem? I thought liquid funds were safe!  Just a sample of how many investors feel. In this post, I discuss these issues and how to minimise risk associated with liquid funds.

First, let us get the obvious out of the way. No mutual fund is safe. Risk cannot be avoided (without enhancing other types of risk)  and can only be minimised.

Second, why should one use liquid mutual funds? Because the AMC or the fund sales guys tell you that money sitting idle in your SB account or fixed deposit is a crime? Because they say that you can get better returns in a liquid fund? Hogwash! If you fell for it, you’ve been had!

Third, what is the big idea of wanting to earn 1-2% more return from an emergency fund?!

What is the use of a liquid fund?

Well, it is meant to earn “a bit more” than a savings bank account. At what cost? (1) the redemption is not instant and (2) the risks are much higher.

The typical liquid fund monthly return can vary by +/- 0.25%. You may think that this is “nothing”. However, it is the unknown risks that matter.

That +/- 0.25% is the market demand and supply variation. This is what we usually perceive on a day to day basis and this is what star rating agencies use as part of their star ratings.

The unknown risk exists everywhere. We do not expect our bank to collapse. Even if we think about it, it is reasonable to expect that a “well-established” bank is unlikely to collapse overnight. Of course, it can and has happened but we have to consider probability at some stage or forget about returns.

In the case of a debt fund, the unknown risk is the change in credit worthiness.  Unknown in the sense, not well understood by many.

Let us imagine ourselves to be a money lender. We lend money to only known people. Their credit-worthiness demands a low-interest rate. Suppose we get greedy and lend to one untrustworthy person at a high rate.

We may think we have “diversified risk” by keeping untrustworthy borrowers low. But imagine the hurt to our cash flow if that person defaults on payments.

That is life. We have to take risks to make more. If we repeat the mistake, then we alone are to blame for the loss. As argued yesterday, I think Taurus made a similar mistake when they rolling over the tainted bond.

This is not a “small amc, trying to compete” problem. It has happened to ICICI and Franklin before. AUM size has little to do with this, except perhaps, the concentration of holdings. A fund with large aum tends to hold many securities with smaller portfolio weights. This could reduce the fall in case of a credit rating downgrade. But then again, what is big or small is quite subjective.

What can we do as investors?

We cannot control the behaviour of fund managers. So let us focus on what we can do.

Option 1: avoid debt mutual funds I am not a mutual fund salesman. So I present this option without batting an eyelid. Who says you need debt mutual funds?  You don’t.

If you are unwilling, uninclined, unable, to appreciate risks or unlikely to understand them, stay away from debt mutual funds or any product for that matter.

As mentioned many times here, never invest by looking at star ratings or past performance. Invest only in what you can/wish to understand.
Read more: 

Option 2: minimise risk. This means minimising returns too. Within the liquid fund category, you will find funds that dabble in lower than AAA bonds to varying degrees and funds that handle only cash (overnight or short-term collateralised borrowing or CBLOs). Choose the cash management funds. They will have 1/2 stars only, though! More on this later.  This will not eliminate risks, but minimise them to a reasonable extent.

The other option is to eliminate credit risk, but embrace minimal interest rat risk by stick to very short term gilt (GOI) bonds. Read more here and here

Option 3: Take some risk but keep an eye. Risk = effort. So if you want to or if you are already using a liquid fund that invests in any kind of non-sovereign debt, then there is no option but to keep any eye on the portfolio once a month. If you are uncomfortable about the holdings, pull out.

I know that this is not a great option, but if a liquid fund can fall 7%, anything can happen. We cannot predict these, but at least can be mentally prepared better. I know, easier said!

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The scheme information document is quite vague. Study the fund factsheets for random months in the last few years to check how the portfolio has changed. I prefer a fund that does not change investment style (even if that is risky)

Do not be scared: I know many investors who intelligently use debt mutual funds after retirement. It is not impossible. In fact, even if you do not have any need for debt funds now, it makes sense to learn more about them so that you can use them later.

What about my current liquid fund?

Please study the key information document (KIM) or Scheme information document (SID) to understand risk. Check past factsheets as mentioned above. Do this as a simple learning exercise without pressure.

Debt Mutual Fund Selection Guides

How and When To Select Ultra Short Term Debt Mutual Funds

Smart Ways to Invest in Corporate Fixed Deposits

How to Select Mutual Fund Fixed Maturity Plans (FMP)

Should I buy Long Term Gilt Mutual Funds?

How to choose debt mutual funds with no credit risk and low volatility

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  1. Option 2: minimise risk – How can we minimise risk by investing in funds (which currently invests in AAA bonds) but they can always be greedy and invest in low quality credits or take no action when AAA bond rating is degrarded (similar to Tarus)? I believe it is not feasible to actively monitor the holding of funds actively so Option 1 makes perfectly sense to me. Invest into safe instrument like PPF, FD for debt.

  2. Got it. I misread the option. Clearly it states using Cash Management Funds. Thanks for the post. This question has been in my mind from the time I read about Torus. KISS is the principle which one should strive for even if that means lower returns (but higher inner peace).
    Equity funds are so simple in comparison to debt funds partially because everyone (presumably) knows that equity is risky but expect debt funds to be risk free (even I tend to believe in that philosophy till read about defaults in various funds).

  3. Surely an useful post… liked the stament …”In fact, even if you do not have any need for debt funds now, it makes sense to learn more about them so that you can use them later.”

    By the way, awaiting for some more post on arbitrage funds… specially on selection methodlogy/process. You mentioned in earlier post that you wolud write about the selction methods … I’m not sure if you have already made that post. If not, request some more insight on this category of MFs.

  4. I have been trying to understand debt funds for a while now. I want to invest for my 70 year old mother. She gets family pension and interest income from FDs. This is more than sufficient for her needs. Since the FD rates crashed to around 7.3% for Sr citizens from the high of 8 to 9%, I was thinking of channeling some of her investments in FDs to debt funds but I am more confused than ever. As Pattu says in the article, for a 1 or 2 percentage more, is it worth taking such a risk and trouble.

  5. Sir ,

    Last decade every tom dick harry was investing in real estate – now the herd is rushing towards equity through SIP . I’m amazed when experts talk about asset allocation to include only equity and debt as part of portfolio now that real estate and gold has lost its shine . My last decade and a half experience is a person should have asset allocation distributed in all classes – real estate , gold , equity and debt plus simple insurance – rebalance yearly/ bi -yearly .
    A person can have combination of autosweep FD , PPF , EPF for debt . There is no need to touch debt fund – you can buy a fund with all AAA ratings but a risk of degradation always exist after you buy .
    Ironically experts are misguiding retired people to invest in long term debt funds which are more complex and riskier than equity . Auto SIP in equity is another hogwash for distributors and AMCs to make money . Capital assets like equities , gold and real estate do not compound – only debt instrument compounds with time . Capital assets is buy low , sell high – rebalance periodically .
    Market gives you lower range at least 4-5 times a year and you’ll know it without tracking daily . Make your equity MF investment at these points in a large cap , multi cap , midcap fund . This strategy has given me 27% returns in the last decade and half with minimum risk .
    Lastly , commn man wake up – there is no such thing as financial planner who will think about your well being more than his – take your finances in your hands !

  6. One question, this article is talking about keeping money safe, but how does keeping it in savings account avoids loss of its value? A 4% returns ensures we are losing it silently.
    Suddenly equity funds looks safer compared to debt? A 50% crash in stocks will make people feel debt funds are as safe as a house.

    1. Context matters! I am talking about keeping money safe in the short term. I dont care much about inflation or real returns in the short term as the risk associated with trying to beat that with equity is way higher over that period.

  7. Sorry to say that , this is the worst article I have read in free fincal in the last 1 year !!

    Tell me a better option other Debt funds to the idle money in bank ?

    1. No problem at all. Can’t please everybody. The option that lets a person sleep in peace is the “better option”. One size does not fit all.

  8. Sir,
    So its clear that even in case of liquid /UST, credit risk is there always.However company which gets defaulted, having 2% share in the portfolio then its just 2% drop in one’s corpus right ?.
    So ,do we need to worry too much on this marginal ( subjective ) risk.. Please clarify and explain, if I am wrong. Hoping for a discussion on this.

    Can you let us know which UST Fund invests only in PSU and SOV deposits only? ( Searched could not find )

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