Fixed Income Fund Series1- Analysing Liquid Funds

This post is inspired by my observations on Twitter. I am beginning to realize that there is scant awareness on Fixed Income in general. Fixed Income Funds in particular, are a poorly treated or debated cousin in comparison to the Equity Funds category. Consider it my professional bias, as I always conveniently presumed that atleast the Liquid Fund category - the plainest vanilla product from the Fixed Income stable, needs no education and everyone who trades and invests in the markets for a living or their interest understands them thoroughly. Turns out that is not the case.

Fixed Income Funds have many confusing sub categories, hell yes I have to admit that. Not possible even for the pros to figure without explanation. Here, I shall try and simplify on the Liquid Funds to begin with. Hopefully, I shall throw light on other categories too, sooner than later.

What is a Liquid Fund?

A scheme that does not invest into equities at all. Yeah! You read it right, we have funds like that too. A scheme which will invest in debt, money market instruments which mature within 91 days. Just like if you borrow money from a friend and have to return it back, similarly the GOI, banks, corporates, financial institutions, NBFCs also come to the market to fund their working capital requirements. Their papers are subscribed by the mutual funds and others. The thing is your credit score is irrelevant and default imminent ;) but these entities in debt markets need a short term rating to do so and history of default so far in the category has been extremely far and few.

Why do you need a Liquid Fund?

This is essentially a tool that you use for temporary cash parking. This tenure can be as low as a single day to as high as the time you gain salvation in your future lives. If you are an ultra-conservative saver and keep money under a mat, you need liquid funds. If you are a fan of Fixed Deposits, you have committed a crime and if you let it sleep in Current/Savings account, your crime just doubled. Reasons enough for you to have a liquid fund.

Who are the investors in Liquid Funds?

As on February 2018, Out of the total industry size of 22.2 lac crores, approximately 12 lac crores is in fixed income funds, out of which 3.87 lac cores is in liquid and money market funds.

Average AUM in Liquid Funds as on 31st Dec 2017
Investor Classification	AUM (Rs. Cr)	% to Total
Corporates	238256.63	83.22
Banks/FIs	9603.31	3.35
FIIs	49.75	0.02
High Networth Individuals*	30864.11	10.78
Retail	7530.53	2.63
Source : Amfi

As you can see from the data, 87% of investors in the category are institutional in nature while HNIs & retail just about hold 13%. The smart money already lies in here.

How to Choose a Liquid Fund?

1 month rolling returns for the period 2013-2018  on a daily rolling basis
	Minimum	Maximum	Average
Liquid Fund Category Average (Direct Plans)	5.16	10.89	7.86
CRISIL Liquid Fund Index	2.08	15.44	7.80
* The funds considered are more than 1000 crs in AUM

Funds between 10 bps of average returns	Total	%
31	39	79%
Source : Icra Research

A 1 month daily rolling return analysis for a 5 year period since the advent of direct plans shows an average return of approximately 7.86% for the category, with a standard deviation of 1.15. 31 funds out of the 39 considered in the analysis generate returns between 10 bps of the category average range.  The reason I mentioned the category average and not scheme specific is, that it is almost impossible to differentiate one liquid fund from the other. Chasing the alpha, tracking sharpe ratios, calculating the momentum, top quartile performers, sector breakup analysis are indeed non-starters for the category and will not add value but keep one sufficiently busy. It is a zero sum game over a period of time. And for those, who will now ask looking at the above on how can I invest in Crisil Liquid Fund Index, you cannot! The reasons it looks fabulous on max returns generated is technical and explicable. But we can skip that.

 Then what should one do?

Pay attention to a few details then just sit back and relax.

SEBI Guidelines: Post the Amtek Auto crisis, SEBI realized that it was prudent to have sectoral limits for mutual fund schemes. Currently, a debt oriented MF scheme cannot invest more than 40% of their corpus into NBFCs & Housing Finance Companies. Not more than 25% of the scheme corpus in NBFCs at all. The single issuer limit is capped at 10 % & 12% with requisite approvals. There is no limit to holding G-secs, T-bills, CDs and papers issued by government backed institutions. What this means for you, is that the concentration risk has been reduced to a great extent by the regulator without you having to bother about the same.

Portfolio Composition: Other things being equal, the only way for a fund manager to enhance returns in Fixed Income is either through interest rate risk or credit risk. Since the former cannot bear any weight in Liquid funds which run zero to low mark to market component (securities have to be valued at their traded value /fair value for maturity beyond 60 days) the later can do have some bearing on returns.  In the Long run we are all dead, and in the short term everything in debt markets is A1+ rated (This was a Joke). The trick is to pay attention to the credibility of the issuers. I am a bit cynical about the rating world but at least it is a good starter. It provides the much necessary illusion of comfort. So essentially, it will be good to pay attention to the long term ratings of even the short term issuers. It is best to stick to quality portfolios.

Securities Breakup: It will be wise to know the portfolio breakup in terms of the type of securities. The ratio of CBLOs, Repo, Commercial papers, T Bills, Certificate of deposits, Bonds with residual maturity of less than 91 days, FDs (yes they do invest a small part there too). This breakup will essentially tell you how liquid are the Liquid funds in truest sense. 

AMC: The pedigree, the long term track record of the AMC, the ability to show resilience in the down cycles, the management of credit events whenever they took place; these are qualitative factors and require attention. But these soft factors are important when you do not have much time to analyze & wish to entrust your hard earned savings to someone.

Cost: Last but the most important metric. The total expense ratio charged by the funds is essential to know. The lower the better, the lowest may not be the best.  As I just gave you the other reasons to pay attention to.

What not to pay attention to?

I may have my own prejudices here, but I am not a big fan of the following:

• Independent websites research ratings. Some of the funds which went kaput post the default crisis in Amtek Auto had the best ratings

• Top Rankers - They changes every few days, weeks. Over a period of time, the returns across schemes revert to the mean and net result is insignificant. In fact a prudent risk mitigating norm would be to question a fund manager if he consistently stays in the top quartile for a longer period of time as to what is he doing differently to achieve such a result?

• Sharpe Ratio: Return per unit of risk generated may be immaterial here. As the more thinly traded securities in a portfolio, more illiquid it will seem and thus less volatile. A portfolio consisting of T Bills will thus have a lower Sharpe ratio compared to a portfolio of commercial papers. But that does not really tell you anything but adds the much revered complexity.

And well, you have Liquid ETFs too. They may not be the most optimal, but to a certain set of investors, read stock market traders, it indeed is the most convenient way of investing. Convenience trumps returns many a times. This beautiful quote sums it up “Not every dollar of ours is meant to build wealth.  "Every dollar needs a purpose, but that purpose will differ depending on our current goals.” – J Money.

So the next time, you have to invest in a Liquid Fund or ETF, ponder on the points mentioned herein and choose to use your energy and intelligence for more complicated investment decisions. Keep this simple!

Disclaimer: I work with DSP BlackRock Asset Management. My views will have a strong dose of availability and outcome bias. The views and opinions are my own and obviously not of my organization.