The Ultimate Guide to Liquid funds

This is the 3rd post in the debt mutual fund investing series. If you have the time, it would be great if you could go through the earlier posts in this series –

Part 1 – A primer for investing in debt mutual funds (Link 1)
Part 2 – 8 factor framework for analyzing any debt mutual fund (Link 2)

There are primarily 8 categories of debt funds:

  1. Liquid Funds
  2. Ultra Short Term funds
  3. Short Term funds
  4. Income Funds
  5. Dynamic Funds
  6. Accrual or Credit Funds
  7. FMP
  8. MIP

Phew..8 categories ..this seems to be complicated..

So instead of breaking our head over the complexities, lets try and break it down to the basics and nail down the few categories which will matter the most to us. In fact for my personal investments, I like to keep it extremely simple and stick to only the first three categories i.e Liquid, Ultra Short Term and Short Term Funds !! So hang on for a while and we will get this thing sorted.

If we strip down all the jargon, the underlying difference across the categories simply boils down to what type and extent of risk are the funds taking to improve returns via

  1. Interest rate risk (measured via modified duration)  
  2. Credit risk (measured via the % of portfolio with lower than AA securities))

With this in mind, let us explore various categories..

For all temporary parking of money which we need within 1 year, we can consider
       1. Liquid funds – upto 3 months
       2. Ultra Short Term funds – 3 to 12 months

Liquid Funds (Think of it as an alternate to Savings Bank Account)

Liquid Funds invest with minimal risk in short term debt instruments with a maximum maturity of 91 days. This is captured in the “Average Maturity” and in practice, for most funds it averages to less than 2 months. They have the lowest risk and are ideal for parking temporary money.

(Ignore if you find it a little technical: The instruments where liquid funds invest generally include CBLO, certificate of deposits (i.e short term lending to companies), commercial papers (short term lending to companies) and treasury bills (short term lending to government) and term deposits (bank FD) )

While investing in Liquid funds generally returns are not the top priority. I mean have you ever worried about your savings bank account paying you only 4%. The priority is safety, liquidity (i.e can be taken out anytime) and returns – in that order.

So as expected, these funds do not take credit risk as they are predominantly invested in AAA equivalent bonds and also do not take interest rate risk (they have very low modified duration) to improve returns. This basically implies that liquid fund NAV returns will generally be very stable as the underlying returns are predominantly driven by interest income (from the underlying debt securities) which accrue everyday.

Approximate Return Expectation from a liquid fund = Net YTM = YTM-Expense ratio

Also remember that while investing in liquid funds, if interest rates increase our returns also increase and if interest rates decline then our returns will also decline. 

Liquid funds for people like us can be used in several ways. For eg

  1. Temporary parking: For eg, every month when I get my salary, I immediately park my intended savings in a liquid fund. Then as and when I find time, I transfer it to equity funds or any other option which I like at that juncture.
  2. For systematic transfer plans into equity funds: Sometimes you may have a large amount of money which you don’t want to put in equities at one shot. So you may put it in a liquid fund and do a systematic transfer plan into equity funds or manually move it as and when you want.

So how do we select our liquid fund??

The first advantage when it comes to selecting a liquid fund is that the chances of a big mistake is not there. Since most of them prioritize liquidity, do not take credit risk (except for a select few funds which may take minimal credit risk to show better performance) and have very low modified duration, the returns across different liquid funds is generally in a narrow range and most of the return differential can be explained in terms of expense ratio and portfolio composition.

In terms of the portfolio composition, the returns are higher in the order of Commercial paper (CP) > Certificate of deposit (CD)  > Treasury bill (T Bills). T Bills and Certificate of deposits are more liquid compared to Commercial Papers. A liquid fund with higher exposure in commercial papers is considered to be more volatile as these securities are generally not as liquid as CDs or T-Bill.  So the fund may be producing higher returns but will also have a slightly higher risk. Hence if you are extremely conservative choose a fund which has a lower % of Commercial Papers).

Simple steps to choose our required liquid fund

  1. Stick to large AMCs
  2. Check credit quality
  3. Go for a fund size above 1000 cr
  4. Lower the expense ratio the better

When it comes to Debt funds, I generally prefer to stick to major AMCs such as ICICI, HDFC, Reliance, Kotak, IDFC, Axis etc. Is there something wrong with other AMCs. Of course not but given the narrow range of return outcomes I am more comfortable investing via the larger names. Some funds under the large AMCs are ICICI Prudential Liquid Plan, Reliance Liquid Fund – Treasury Plan, IDFC Cash Fund, HDFC Liquid Fund, Kotak Liquid fund, Axis Liquid fund. You can consider any of the above. I generally use IDFC Cash Fund. If you want more options you can check here – Link

Snapshot
Liquid Fund Data

Most importantly, let’s not get too lost in the tendency to over analyse (which yours faithfully gets caught into often), as anyway the return differential is not going to be too high and the primary reason for using liquid funds is for safety, liquidity, convenience and of course some reasonable returns.

In fact when I was researching for this article , I found that there is a new app called Finozen which has just started with the premise of letting you switch back and forth between a savings bank account and liquid fund. I never thought someone could build a business model around liquid funds. But nevertheless simplicity always has its charm. They have a nice 30 second video on liquid funds. Do check if you have the time – Link (by the way I have no clue on who they are..nor am I recommending them..Found the idea to be interesting and hence the mention 🙂

At the current juncture the Net YTM (i.e YTM- Expense ratio) for most of the liquid funds work to be around 7%. So the daily returns going forward assuming interest rates remain the same will be roughly 7%/365 = 0.019%. This implies that if I invest Rs 1 lakh, I can expect approximately Rs 19 to get added everyday.

Now while liquid funds are for all practical purposes extremely safe and provide better returns than an SB account, we also need to be aware of some possible risks.

  1. Sharp increase in interest rates:
    On 16-Jul-2013, India was going through a currency crisis due to the announcement of Fed Taper. As a result there was a sharp increase in interest rates of up to 2% leading to negative returns in liquid funds for a day. Kindly go through the articles to understand what really happened –  Link 1 Link2

    Now what if we had a similar scenario like that repeat and interest rates went up by 2%. Taking the example of IDFC Cash Fund, it currently has a Net YTM = YTM-Expense ratio of 6.95%. Therefore daily returns from interest accrued is 6.95%/365 = 0.019% or Rs 19 added per day for every 1 lakh invested. It has modified duration of 0.08 years – which means that the negative NAV impact in our fund for a 2% increase in interest rate would be a  -2%*0.08 =-0.16%. Now if you adjust for the interest income everyday (i.e 0.019%) then the negative impact will be -0.14%. Or in other words, Rs 1 lakh investment would be roughly down by Rs 140 to Rs 99,860. This is equivalent to 0.16%/0.019% = 9 days of usual returns in the fund. Now remember that our Net YTM has now increased from 6.95% to 8.95%. Therefore daily returns from interest accrued post the interest rate increase is 8.95%/365 = 0.025% or Rs 25 added per day for every 1 lakh invested. So to compensate for the loss of -0.14%, we will need to wait for 0.14%/0.025% (or Rs 140/Rs25) i.e approximately 6 days.

    While these are rare events, whenever they occur there will be a lot of panic which will be disproportionately exaggerated by the business news channels. So if in case something like that happens, the most important thing is not to panic as we clearly know how liquid funds derive their returns and to remember that its only a matter of waiting for 7-10 days before we tide over our temporary decline. 

  2. Crisis scenarios leading to significant redemption from the funds and the fund not able to sell underlying securities due to low liquidity (read as no buyers):
    When this scenario happened last time during 2008, since redemptions were high from liquid funds and buyers were not there, few funds were forced to liquidate their underlying debt securities at lower prices thereby taking an NAV impact. The larger AMC’s were able to tide over this as they arranged for temporary loans/support from their sponsors after which RBI came to the rescue. So this is the reason why I generally stick to large AMC’s with strong debt fund management teams.

Parting Thoughts:

  1. Think of Liquid funds as an alternative to our Savings Bank account
  2. Typically used for parking of money for time periods upto 3 months
  3. No credit risk and extremely low modified duration
  4. Returns are predominantly from interest income – hence daily NAV movement is extremely stable
  5. Returns across different liquid funds is generally in a narrow range
  6. Hence, opt for well established funds with strong pedigree

So with that we come to the end of our liquid fund analysis and I hope you found it useful. Next week we shall discuss the remaining categories.

Happy investing 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments

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See how easily you can create your own financial plan in 15 minutes

Do you have a financial plan??

Image result for funny quotes on future plans

Don’t worry if you don’t have one. Be with me for the next 15 minutes and we will get a simple yet effective financial plan done for you.

The backdrop..

All of us have dreams which are extremely close to our hearts. A happy family, our kids in the best colleges, memorable vacations, a nice cozy home, starting your own company, a comfortable retirement and so on…While as unromantic as it may sound, the hard truth is that most of them also need enough money to get fulfilled.

A financial plan for normal people like us, is a simple reality check of putting a cost to our dreams and figuring out ways to make them feasible.

So when I went about trying to find a simple planner online, one of the issues I faced was that, most of them were too complicated. The ones which were simple enough calculated a monthly required investment amount which was constant and did not increase. This meant, I got a horrendously large monthly required investment amount given my goals which also meant I was staring at a “put-your-entire-salary-into-investments” kind of a future. But its impractical to assume that my salary would remain the same for the next 10-20 years and it’s reasonable to assume that my investments will keep increasing let’s say conservatively by at least 5-10% every year. Since I couldn’t get my hands on a simple planner which let me do this, I have created my own basic planner which you can download from the below link.

Download the financial planner here: Link

How does it work..

Financial Planner

10 fairly simple steps:

  1. Enter your goal in column under the name “Goal”
  2. Enter the age of the person for whom the goal is planned
  3. Enter the age at which the money is required
  4. Enter the expected yearly increase in costs (i.e inflation) for the particular goal (In India Inflation historically is around 7-8%)
  5. Enter the goal’s current cost (i.e how much does it cost today)
  6. Enter the % by which you want to increase your yearly investments (approx should be equal to expected salary hike %)
  7. Enter existing overall investments value (if any)
  8. Enter the expected portfolio return from your investments
  9. Repeat the above steps for all your goals
  10. Press the “Calculate” button

Tips while filling the planner

  1. Don’t get too bogged on getting each and every assumption precisely right to the final decimal point. Honestly, no one knows what the future exactly looks like and so the basic idea is to get an approximate estimate of our future financial needs to help us plan
  2. Historically, inflation is around 7-8% in India.You can use that for most of the goals. Education and Housing might have higher inflation so I generally assume it to be around 10%.
  3. Play around with the portfolio returns – Get a sense of monthly investments required if you put your savings only in safe but lower return generating Fixed Deposits, volatile but higher return potential of equities etc. It lets you appreciate the importance of having a good investment process which can improve your returns.
  4. Retirement amount – Calculate it as 18-20x your annual requirement for getting inflation adjusted annual income for the next 30-40 years. I will do a separate post on the logic and mechanics behind creating an annual income flow.

Sample plan..

Lets take the case of someone who is around 30 years old, married and has a 1 year old kid. He wants to plan for his kid’s education (current cost of ~ Rs 8 lakhs for UG at 17 years + Rs 20 lakhs for PG at 21 years), kid’s marriage at 25 years (current cost of ~Rs 20 lakhs ), retirement at 60 years (current cost of ~ Rs 2cr) and purchase his own house after 15 years (current cost of ~ Rs 80 lakhs).

Given the above assumptions (you are free to use your own assumptions) as seen from the snapshot of the financial planner, he will need approximately around 1.02 cr currently for all his major future goals (adjusting the future costs for inflation). Now if he has it already, nothing like it. Else (which is most often the case), the next obvious alternative is to save and invest monthly. Normal SIP (systematic investment plan) means that you assume your investments to be constant every month which is impractical as discussed earlier (in this case he needs to invest approximately Rs 1.06 lakhs per month). Now the top up SIP is where he will increment his investments by 5% every year. Now the amount works to be around Rs 79,000 per month. If the amount is too high, given his salary, then he might need to take a hard look at his individual goals and prioritize on a few goals for the time being .

All of us have different priorities/needs and hence the above example is just to give you a sense of how someone can go about with it. So what are you waiting for. Go ahead and create your own financial plan.

Once you are done, our ability to fulfill our goals boils down to a combination of how much we can save and how well we can invest.

Obviously, the savings part will have to be figured by you.

On the investment part, don’t worry. I have got you covered. In my future posts, I will discuss on how we can go about putting a simple investment process in place.

P.S:
Just in case you find any difficulty in using the planner, kindly let me know via the comments so that I can help you out 🙂
By the way, my guess is, there should be far more comprehensive financial planners available on the net. While I find my own version sufficient for my personal use, you can consider this as a quick and effective starting point and can gradually explore the more comprehensive version of various planners available.

Mind your Inflation

How do I know if I am setting the bar too high or low with respect to my expectation on future returns?

First let’s address the question of the lower bar. What should be the bare minimum returns, I should generate over the long run.

In order to address this question, let’s take a step back and ask a fundamental question:

What is investing?

In simple terms, it is putting aside some money in the present in the hope of receiving more money in the future.

Today let’s assume I have INR 6 lakhs. I have the option of buying a car right now. But however I decide to postpone my purchase and instead save and invest the money in an F.D which offers me 8% return so that I can increase my money and buy a better car.  Fast forward 5 years, I have INR 8.8 lakhs and I am extremely happy as I have more money now. So as per our understanding of investing, we had put aside INR 6 lakhs five years back and received more money i.e INR 8.8 lakhs. Now I decide to buy a better car as I have more money. But I receive a shock when I go to the car showroom. The cost of the same car which I had wanted to buy 5 years back, now costs 9.6 lakhs !!

Though my investment had increased by 8% the cost of my car has increased by 10%. So while it feels like I have grown richer given the increase in money, the reality is that I have actually grown poor as the same car which I could have bought 5 years back cannot be bought now. Now why did this happen? The cost of my car increased at a higher rate than my returns.

This practical reality of higher costs is what a nerd calls “Inflation”. This means that our understanding of investing has to be tweaked to account for the “hidden thief” called inflation.

Let’s redefine investing from a practical point of view, as forgoing consumption now, in order to have the ability to consume more at a later date i.e Investing is not just about increasing money but the actual purchasing power.

Hence your investments should grow more than inflation to increase your purchasing power. So coming back to our question on what is the bare minimum return that one must strive to achieve – the returns must at least equal inflation if not more for preserving your purchasing power.

How do we know the inflation for the future. While I profess no prediction capabilities, as Keynes a famous economist puts it, the idea is to get it approximately right rather than precisely wrong.

Cost Inflation Index

Historically over the last 30 years India has had an inflation of around 7 to 8%. Hence its reasonable to expect future inflation to revolve around the same levels and therefore we set a cut off of a bare minimum at least 7.5% for your investments.

Let’s assume you have constructed an investment plan for generating a 15% return expectation. This means that your investments will be 4 times in 10 years while the costs would double (assuming 7.5% inflation). Hence an investment of 6 lakhs = purchasing power of 1 car will translate to approximately 24 lakhs while the car cost will be INR 12 lakhs. So after 10 years you will be able to buy 2 cars. Translate that into 20 years, you will afford 4 cars and 30 years you can afford 8 cars.

This is how wealth is created – a combination of returns above inflation + adequate savings + long time period

Now what if inflation comes lower let’s say to around 5%. This would imply that a 13% return is enough to replicate the same impact of a 15% return under 7.5% inflation scenario. Similarly if inflation becomes higher at 10%, then we need around 18% to replicate the same impact. So you can notice that there are three different returns 18%,15%,13% yielding the same result. The reason is the underlying not-so-obvious component – Inflation.

Thus the idea is that your return expectation instead of being fixated to a number should be relative to inflation. This is called real returns (actual or nominal returns – inflation). In the above case the real return is around 7.5% (15% actual return – 7.5% inflation). Hence when you set your target for an investment portfolio and are evaluating your returns focus on the real returns and not on the actual or nominal returns.

Quick Takeaway:

  • Investing = increasing purchasing power and not just money
  • Inflation is the not-so-obvious culprit which steals away your returns; Keep an eye on it
  • In India, Inflation historically has been around 7-8% ( basically that means our costs go up 2 times every ten years)
  • If your returns are below inflation, you are doing a bad job
  • Focus on real returns i.e Actual returns – inflation

Now that we have a fair idea on compounding, inflation and real returns let’s move to our next question

How do we set reasonable return expectations for our investments?

Great Expectations !!

Recently I had a conversation with a family friend of mine, who also happens to be a CFO in a leading Infrastructure company. Since I was working for a wealth management firm, he casually asked me on how much returns do our clients generally make. I answered “mostly around 12-15%”. For a minute he stood shocked. “What?? Just 12-15% …I thought you guys must be making at least around 30-35% returns for your clients”..It was my turn to be shocked !!

This question serves as an inspiration for this post. Now before we move on, pause for a second and answer this. How much return do you expect from your investments (real estate, stocks or mutual funds or gold etc) for the next 20 to 30 years. Is our current expectation in line with reality? If no, what returns can we reasonably expect from our investments. The following post will try to address these questions. Have you heard about the magic of compounding? I know this concept has been beaten to death, but somehow intuitively most of us tend to find it extremely difficult to appreciate its relevance in our lives. Let’s understand its beauty, by taking an example of someone who expects to make 15% annualized returns.

Compounding formula: 

Final value = Invested amount * (1+returns)^no of years 

  Compounding @ 15% (graph)
The above illustration indicates the no of times your money is multiplied. For eg at 15% annualized returns your initial money invested multiplies 4 times in 10 years

Did you see that!!

While the effect of 15% returns on your investment is gradual in the initial years the impact magnifies dramatically as your investment period increases.

The logic is pretty simple – you can see that the money approximately doubles every 5 years. As you move past the first 20 years, in the next 5 years your doubling effect is phenomenally magnified given that you already have a 16 times initial amount as your base. Similarly between 25 to 30 years the multiplying effect is doubling on a 33x base which gives you a 66x returns. So as seen, an additional wait of 5 to 10 years brings about a significant change in your final investment value or put in other words, the earlier you start the higher is your future wealth.

Hence the key thing to remember is:

Compounding or the multiplier effect is back ended

To benefit from compounding we need to have 3 things in place:

  • Adequate savings to be invested
  • A reasonably long time horizon for investing – Start early !!
  • Consistently generate superior returns over a long period

For a much better and deeper understanding on the topic, please refer to the link by a brilliant blogger called Jana – https://janav.wordpress.com/2015/10/03/lecture-notes-the-joys-of-compounding/

 Long term Compunding @ different rates

Now that we can appreciate the effect of long term compounding better, let’s go back to the initial conversation that I had. Remember the shock that someone couldn’t earn even 30-35% returns. Now to put that in perspective, if I could consistently earn 30% return, it implies a multiplying effect of 2620 times in the next 30 years or 190 times in the next 20 years. Just take some time to register the impact of these nos. It means if I have 1cr and I can generate 30% returns I am staring at 2,620 cr in 30 years and 190 cr in the nest 20 years. Phew !!

So the next time someone tells you he made 30% or more (blah blah) in a year investing in this land, property, xyz stock etc… Pause. Ask him “Boss..Will you be able to do this for the next 10-20-30 years. Do you have any idea what that means in the long run ?”

The idea is not to conclude that generating high returns (lets say >20%) is not possible. But the fact that generating higher returns consistently over the long term is definitely not easy.

You had also started with some expectations in your mind. Check with the table to appreciate the true long term impact of your expectation. Is it too high? Will you be able to do that consistently over the long term?

While there will be several investments which do well in the short run, what really matters is not the returns we make over a 1 or a 3 year period, but the ability to “consistently “ generate superior returns over a long term. Hence it is extremely important that we do not get carried away by abnormal returns in the short run but rather have a reasonable idea on the long term potential of your investments.

This leaves us with a few questions:

  • How do I know if I am setting the bar too high or low with respect to my expectation on future returns?
  • How do I put in place a plan to generate “consistent and superior returns” over the long run
  • Given my requirement and needs, what is the adequate amount to save and invest?
  • Does it require a lot of knowledge and time?
  • Is it possible to improve my returns?

(to be continued)