With interest rates expected to remain volatile in 2005, it would be prudent to stay away from long-term income funds or gilt funds for some more time. What you could do is park some of your savings in a liquid fund or a floating rate fund.
In 2004, liquid funds gave an annualised return of around 4.5 per cent and looking ahead they should yield between 4.75 and 5.25 per cent annualised (pre-tax).
If you opt for the monthly dividend option, the fund will deduct distribution tax, monthly, at the rate of approximately 14 per cent.
So, on a return of 5.25 per cent annualised, you would earn a net return of 4.5 per cent. On a bank FD of 5.25 per cent at a tax rate of 30 per cent, you would earn 3.68 per cent.
In case you opt for the growth scheme and remain invested for more than a year and get an indexation benefit, of say 3 per cent, you would pay tax only on 2. 25 per cent at the rate of 20 per cent. So, the effective return would be 4.8 per cent on a gross return of 5.25 per cent.
Liquid funds are virtually risk -free since the money is parked in cash and cash equivalents and money market instruments such as treasury bills, so your capital remains intact.
Says G Ramachandran, head, investment advisory services, ICICI Bank, "Liquids and floaters are currently because of low duration risk and, hence, help in reducing portfolio volatility. They should deliver superior risk-adjusted returns compared to gilt and income funds."
Pedigree: What's in a name? Plenty when it comes to mutual funds. There can be no substitute for an impeccable track record.
If a Fidelity or a Templeton has decades of reputation behind it, there must be a good reason for it. As Amit Sah, director, Retail at Citigroup, puts it " We attribute a lot of value to the reputation of the fund, its very important where you put your money."
Size: The size of the fund is important. As Dhawal Dalal of DSP Merrill Lynch explains, a bigger fund will be in a better position to absorb better any shock to the market in terms of a sharp move in interest rates.
Besides, as Ramachandran observes, "given the high level of investments by corporates in mutual funds (over 50 per cent) it is better to avoid concentration risk in such funds. So, it would be wise to stay with liquid funds that have a reasonable large corpus of say, Rs 500 crore (Rs 5 billion)."
Returns: Though past returns are not necessarily indicative of future performance a strong track record is nonetheless a plus point. According to Sah, "fund returns may vary between various periods of time, based on market factors. What should not vary is the volatility of returns versus an accepted benchmark. It is the consistency of performance that matters."
A glance at the strategies and performance of liquid schemes in 2004 reveals that Templeton TMA consistently delivered better returns than its peers. One reason for this was that it parked large sums in fixed deposits.
However, the scheme has taken higher risks vis a vis peers to generate better returns and now stands ranked by some private bankers, in the high risk high return category.
That's because it has more exposure to corporate debt and an increase in exposure to the AA+ and below segment, in December last.
DSP ML Liquidity Fund, which consistently followed an aggressive investment style and outperformed its peer group average in 2004, too has taken a higher exposure to AA+ and below rated paper in the last three months.
HDFC Liquid Fund, say private bankers, trailed the others perhaps because of its conservative style (low risk low return) with a lower allocation to AA+ and below corporate debt though it has been increasing corporate exposure.
The Birla cash Plus scheme, which remained conservative throughout last year (low risk-low return) has increased its exposure to unrated paper in a bid to improve the portfolio yield.
In Sah's view, "there isn't too much harm in putting money in AA+ paper especially if its short-term paper because the fund managers would be doing proper due diligence."
Floating rate funds can also be a good option. The interest rate on corporate paper that these schemes invest in, is reset every three months or every six months. And that minimises the interest rate risk.
However, as Dalal observes, "there is a marginal element of price risk because of the trading in corporate paper.
"Therefore, to compensate, the returns would be marginally higher than that of liquid funds, since corporate paper yields are higher."
Whether its floaters or liquids, however, its a good idea to diversify across fund houses so that you get the right mix of aggressive and conservative approaches.