Which mutual funds should we use for 3-5 year financial goals?

Last Updated on June 1, 2021 at 10:25 am

In this article, let us discuss which categories of mutual funds we can use for 3-5 year financial goals in response to a question on our YouTube channel. We had recently discussed which equity mutual funds to use for 8-9 years SIP and pointed out that asset allocation and risk management is more important than product selection.

While the same is also true for a 3-5 year period, the process is a lot easier. The asset allocation, in this case, is 100% debt. Why? Two reasons. One, there is not enough time to recover from a big loss or a poor stretch of stock market returns. Two, unlike longer-term goals, there is no need to worry about beating inflation with returns as its impact is significantly smaller over shorter periods.

There it is unnecessary to consider any equity exposure over 3-5 years and also quite prudent. So that leaves us with debt mutual funds. However, there are additional considerations before we proceed. Too many investors make the mistake of chasing after returns over the short-term and that too from debt products.

Since inflation is not a major consideration, there is no to break our head over returns. Tax also is not a major consideration.  Reasonably safety of the capital is all that matters. In 3-5 years, we are going to redeem this investment and spend it. Then it gone from our lives forever. Why break our head over returns and tax?

Also, do we even need mutual funds for this period? The answer is no. We can make do a simple recurring deposit or fixed deposit from an established, “too big to fail” kind of bank. Also, see: How to invest without using mutual funds.

Yes, we pay lower tax on mutual fund profits in certain circumstances, but that profit itself is uncertain. To beat the return from a safe FD or RD, we need to take on more risk and this can backfire.

So we shall only consider the need of the typical retail investor: safety >> returns >> tax all within reasonable limits. The data mentioned below is sourced from the Debt mutual fund screener (May 2021). First, let us list the mutual fund categories to be avoided.

Also, many financial advisors suggest funds that invest in bonds comparable to our investment tenure. That is, they may recommend medium duration bonds for 3-5 years goals because these funds invest in bonds of such maturity. This is just terrible advice. Such a fund would be highly volatile. See Poor Debt Fund Advice: Match Investment Horizon With Fund Maturity Profile.

Please do not invest in a debt fund (or equity fund) with the “hope” they would beat FD returns. They may or may not during the time you are invested! Disappointment stems from expectations.

Mutual fund categories for 3-5 years (typical retail investors)

As a typical retail investor, I would like to choose categories with a narrow investment profile. That is, if my need is 3-5 years from now, I would like to choose funds that only invest in bonds much shorter in tenure.  This leaves us with only three categories.

1. overnight funds
2. liquid funds
3. money market funds

Bizarre as it may seem, ultra short term funds invest in longer duration bonds, 1-3 years and even 3-5 years (small exposure). Also, they can take on credit risk. Therefore they are excluded from this list.

Even liquid funds invest in risky bonds so some care is necessary during selection. At the time of writing, the money market category is the most homogenous in terms of duration and credit profile and is well suited for short-term goals above at least one year.

Mutual fund categories to be avoided for 3-5 years by all investors

1. All equity funds except arbitrage fund with good credit quality. Especially equity “savings” funds are a big no-no. Reason: too volatile, possibility of credit risk.
2. Low Duration Funds: Average portfolio maturity 0.5 to 2.7 years 17/25 funds in this category invest in AA-rated bonds (all data as of April 2021 and variable). Too much variation in portfolio maturity meaning the volatility is unknown and possibly too high for 3-5 years. Also higher possibility of credit downgrades.
3. Short Duration Funds: Average portfolio maturity 0.3 to 1.8 years.  15/27 funds in this category invest in AA-rated bonds. Same reasoning as above.
4. Medium Duration Funds: Average portfolio maturity 3-4 years; 13-16 funds in this category invest in AA-rated bonds.  Same reasoning as above.
5. All other debt funds except liquid funds, overnight funds and money market funds. These funds investing in long-term bonds and the NAV would be quite volatile. Credit risk is also present.
6. All hybrid funds. Too volatile,  higher possibility of credit downgrades.

There will also be some funds in each of the above categories which are exceptions. However, there is no guarantee that they would remain so.

Mutual fund categories for 3-5 years (savvy investors)

Investors who can appreciate risks and who have the time and inclination for investigation can consider these categories.

1. Ultra Short Duration Funds: Average portfolio maturity 0.2 to 0.7 years.  15/28 funds in this category invest in AA-rated bonds
2. Hybrid Arbitrage Funds: Average portfolio maturity 0.06 to 1.5 years. One fund out of 27 in this category invests in AA-rated bonds (all data as of April 2021 and variable). Although the portfolio profile of these funds is typically and reasonably narrow, a lack of arbitrage opportunities can drive fund managers to take on credit risk.

In summary, we recommend that investors stick to liquid funds or money market funds for 3-5 year needs. However, there is no guarantee of better returns than bank fixed deposits before or after tax. Also read: Can I use liquid funds for long-term goals with equity MFs?