Some stereotypes endure without reason, such as the belief that liquid funds are a good avenue for debt investments only for the short-term.
For a long-term engagement with debt, across maturity and credit spectrum, investors tend to prefer income funds or long-term debt funds. In a bid to generate excess returns, many even take exposure to assets with lower credit rating. But few go the distance with liquid funds.
It’s time the stereotype is broken. If the findings of a study are any indication, liquid funds also make for serious long-term play.
The study compared the returns of 47 liquid funds and 36 long-term debt funds over 118 months since 2007. The five-year annualised average monthly rolling return of liquid funds exceeded that of long-term debt funds 75% times (or in 88 of the months). While the average outperformance for all the 118 months was by 34 basis points (bps) per annum, for the 88 months in which liquid funds fared better, the average difference was a respectable 58 bps.
The outperformance held on a three-year rolling return basis as well and was, in fact, magnified on benchmark indices.
The annualised average rolling return of CRISIL Liquid Fund Index, which tracks the performance of the money market, exceeded that of the CRISIL Composite Bond Fund Index, which tracks the long-term debt market across the credit spectrum, more than 80% times in the five-year bucket and 68% times in the three-year bucket—and by 46 bps and 40 bps per annum, respectively, at that.
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In shorter buckets, income funds have logged big gains from the recent rally in the bond market, as yields on underlying debt holdings plunged (for instance, the benchmark 10-year G-Sec yields have come off around 80 bps since April 2016). However, long-term investors should view these as one-off events and seek stable returns over the long-term rather than panic or try to time the market.
The tendency to treat liquid funds as an investment avenue only for the short-term may have something to do with the fact that they invest in money market instruments such as certificates of deposit, commercial papers, treasury bills and term deposits, all of which have short maturities. Since the returns are better, those looking to park their money for a small duration prefer these over, say, the savings account, which pays a paltry 4% a year.
The truth is liquid funds match the performance of their long-term peers in multiple time-frames, and also offer several other advantages.
The study, for instance, found that the average management fees of liquid funds was around 0.5% lower than that of long-term peers, contributing significantly to their outperformance.
Also, given that they invest predominantly in papers of shorter maturity, liquid funds come with lower market risk. Longer maturity papers involve greater market risk because, depending on which way interest rates move, losses/gains can be significant. After all, the prices of the bonds these funds invest in move inversely with interest rates (bond prices fall when interest rates rise and vice-versa). This lower market risk is also reflected in the standard deviation of returns of the CRISIL Liquid Fund Index, which, at 0.01%, is much lower than that of CRISIL Composite Bond Fund Index at 0.12%.
Timing the market, therefore, becomes crucial in long-term debt funds—something that is never an issue in liquid funds.
All this bolsters liquid funds’ case as long-term investment avenues, with similar performance levels as long-term debt funds, lower management fees and lower market risk. It remains to be seen how much longer the stereotype holds.
The author, Jiju Vidyadharan is director, CRISIL Research. Views are personal