What Is Turning the Spotlights on Overnight Funds? - Outside View by PersonalFN

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What Is Turning the Spotlights on Overnight Funds?
Feb 26, 2020

Debt mutual fund investors looking to park their money for short term have shown a noticeable shift in preference from liquid funds to overnight funds.

The average asset under management (AAUM) of overnight funds jumped nearly fivefold to Rs 52,525 crore in January 2020 from around Rs 11,567 crore in April 2019. Number of folios in the category doubled to 46,763 during this period.

Overnight fund is a new category under open-ended debt schemes introduced in 2018. These schemes invest in overnight securities, usually Tri-party repo, having maturity of one day.

Key reasons for jump in assets of overnight funds

One of the key reasons for shift in preference from liquid funds to overnight funds is the introduction of graded exit load on liquid funds if exited within seven days of investing. Subsequently, overnight funds became the only category without an exit load, attracting investors' attention.

Following the exit load on liquid funds, Pension funds were allowed to invest in overnight and short-duration mutual fund schemes to park their surplus funds for short term. This could be another reason for rise in the AUM of overnight funds.

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Graph 1: Assets of overnight funds witnessed sharp rise

Liquid funds invest in a variety of instruments such as Certificate of Deposits (CDs) and Commercial Papers (CPs), which carry higher risk as compared to overnight instruments. This was experienced in the case of Amtek Auto, Ballarpur Industries, and IL&FS, where some liquid funds had high exposure to toxic and downgraded papers of such companies.

In comparison, overnight funds restrict themselves to collateralised securities. Further, since overnight funds invest in securities with a residual maturity of just a day, the interest rate risk involved therein is near zero.

This makes overnight funds the least risky among debt and money market funds. However, there can be a reinvestment risk, i.e. overnight funds may not be able to reinvest their proceeds at the same rate of return, but that doesn't cause any capital erosion.

[Read: What Should Investment In Debt Funds For Short Term Look Like?]

Graph 2: Overnight funds are relatively safer among debt schemes

Does it make sense to invest in overnight funds now?

The CPI inflation reading accelerated to 7.59% in January 2020. RBI's MPC is of the view that inflation is rising in the near-term, but it is likely to moderate below target by Q3 FY2020-21. Taking into consideration inflation and other factors, the MPC kept the policy rate unchanged at 5.15% while maintaining accommodative stance.

[Read: Inflation Shock: Here's How It Will Impact Your Debt Mutual Fund Investment]

After the introduction of the external benchmark system, most banks have linked their lending rates to the policy repo rate of the Reserve Bank. This augurs well for transmission to lending rates, as per the RBI.

Thus, we seem to have bottomed out as regards the rate cut cycle, and thus investing at the longer end of the yield curve could prove less rewarding and risky (may encounter high volatility) in the foreseeable future.

Most of the rally at the longer end of the yield curve has already come about since the time RBI started reducing policy rates. Investors would thus be better off investing in short duration funds such as short-term, ultra-short term, liquid, and overnight funds.

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Who should consider investing in overnight funds?

The decision on whether to invest in short-duration, liquid, or overnight funds for your short-term needs should be based on your investment horizon and risk appetite.

Table: Performance of liquid and overnight funds

Category average Returns (Absolute %)
1 Month 3 Months 6 Months 1 Year
Overnight funds 0.41 1.21 2.50 5.47
Liquid funds 0.43 1.26 2.63 6.06
Data as on February 24, 2020
(Source: ACE MF)

If you have an extreme short-term time horizon (of 3 to 6 months), consider liquid funds with high-quality debt papers, which do not have high exposure to Commercial Papers (issued by private entities). Note that liquid funds can generate better returns, but they carry higher risk. So, if you wish to park in a much safer category, you would be better off investing in overnight funds.

However, taking into account that policy repo rates could move either way going forward, you may allocate a small portion of your debt portfolio in dynamic bond funds if you are willing to take extra risk.

But ensure that you approach debt funds carefully and pay attention to the portfolio characteristics and quality of the scheme. A fact is, many debt mutual funds across maturity profiles are grappling with downgraded and toxic debt papers which heightens the investment risk.

So, prefer the safety of principal over returns. Stick to debt mutual funds where the fund manager does not chase returns by taking higher credit risk. Further, assess your risk appetite and investment time horizon while investing in debt funds.

At PersonalFN, we select and recommend mutual funds on quantitative and qualitative parameters using our S.M.A.R.T Score Matrix:

  • S - Systems and Processes
  • M - Market Cycle Performance
  • A - Asset Management Style
  • R - Risk-Reward Ratios
  • T - Performance Track Record

Author: Divya Grover

This article first appeared on PersonalFN here.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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