Debt mutual funds get a passive makeover; will this make it compelling alternative to bank FDs?
Industry leader in the passive debt funds space, Edelweiss AMC is giving investors a taste of another industry-first offering, an open-ended short duration index fund. While its previous innovation—target maturity funds—carved out a new category of debt funds, this offering is throwing down the gauntlet to actively managed funds. Could this new passive offering, together with TMFs, make debt funds a more compelling alternative to bank fixed deposits? Despite years of existence, debt funds have never found much favour with retail investors. While a general lack of awareness is at the heart of this apathy, the industry itself has not covered itself in glory either.The performance of actively managed debt funds has not been anything to rave about. Short duration bond funds have underperformed the benchmark 77% of the times over 3-year time frames for the past 10 years. Managing duration—a measure of interest rate sensitivity—is a key area where actively managed debt funds are supposed to add value. This involves actively switching between shorter and longer tenure securities to take advantage of changes in interest rates. Most debt funds don’t do a good job of this, says Niranjan Avasthi, Head – Product, Marketing and Digital, Edelweiss AMC. “Wrong duration calls often leave funds exposed during interest rate reversals.” While most debt funds put in a strong showing during softening interest rates, the gains are nullified when rates begin to climb.
The second vulnerability of active debt funds has been on the credit quality front. A spate of credit defaults and rating downgrades post the IL&FS debacle in 2018 exposed many funds’ credit practices. Conservative investors in even safer fund categories were left reeling from exposure to sub-standard assets. Fund NAVs eroded sharply, wiping out years’ returns in some cases. A few AMCs were found indulging in shenanigans like inter-scheme transfers of troubled assets.
The bigger culprit in active debt funds’ travails has been high expenses. The average short duration fund charges 1% on the regular plan. It goes as high as 1.5%. “In debt funds, these expenses can really eat into returns,” says Feroze Azeez, Deputy CEO, Anand Rathi Wealth. With the added possibility of duration and credit calls going wrong, investors end up underperforming by a big margin. Add to this the sheer magnitude of choice in debt funds, with multiple duration and risk profiles. Enter Edelweiss CRISIL IBX 50:50 Gilt Plus SDL Short Duration Index Fund (NFO open till 10 February). It is positioned as a low cost savings vehicle to park money over 1-3 years.
The product literature takes a dim view of active debt funds’ ability to add value. The fund seeks to differentiate itself by simply replicating constituents of the underlying index. It will comprise 50% government bonds and 50% state development loans. Each segment will house the most liquid securities falling in four duration buckets —1-2 years, 2-3 years, 3-4 years and 4-5 years. Since index constituents are known, investors have a fair idea of what to expect. Duration management is passive. The fund duration cannot deviate more than 10% from its index at any time, lending a degree of consistency. Default risk is practically negligible. The fund expense ratio is also low at 0.65% for the regular plan.
A viable alternative?
Azeez reckons these funds will usher in cost sensitivity among investors. “In debt funds, where the dispersion in return is negligible, a lower expense ratio can make a lot of difference. Low costs together with sovereign credit profile is the ideal fit for your debt portfolio.” Azeez has been recommending TMFs in recent years. The benefits of passive strategies in debt are clear. TMFs have become popular for many of the same reasons, but with the added element of predictability of return. The passive short term debt fund doesn’t carry a fixed maturity date, so it cannot offer the same predictability of outcome. Your final return will be a function of ongoing interest rate fluctuations.
The index’s modified duration is currently 2.63 years, with the potential to go up to 3 years or more. This suggests a reasonably high sensitivity to interest rates. So it is not meant for use as a liquid fund or for a horizon less than 12 months. Nor is it the ideal vehicle to lock in rates for long time periods. TMFs are better suited for this, given the fixed tenure that nullifies interest rate risk if held till maturity. Compared to TMFs, these funds will allow for a more flexible holding period.
Investors must monitor index replication carefully. While these funds aim to mimic the index, they may not exactly replicate the index at all times. Rules allow them to pick securities other than those in the index, provided they align with the index’s YTM and duration. While this poses no risks in central government securities, picking SDLs is different. Several states in India have been flagged as vulnerable to debt stress. Even though these are assumed to carry zero credit risk, the liquidity profile in some instances is low.
Many active debt funds have failed to beat the benchmark
High costs, along with wrong duration and credit calls have hurt returns.
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This story originally appeared on: India Times - Author:Faqs of Insurances
