Providing better returns than a savings deposit and instant liquidity, cash funds are an ideal avenue for parking your surplus money
Investing in today's financial markets is, by no means, an easy task. In the recent past, the uncertainty surrounding the government's fate, stemming from its perceived failure to handle the Gujarat riots with a stern hand, has sent jitters through the equity markets. Stock prices have withered, especially those of public sector companies, on fears that the disinvestment process, which seemed to be gathering pace, will be halted in its tracks.
But if you thought you could seek refuge in the debt markets to calm your nerves, think again. True, as an asset class, debt products have lesser risks embedded in them when compared with stocks, but after a year that witnessed a free fall in interest rates, the party may have just got over for debt funds.
Fund managers agree that the interest rate movement will no longer be travelling on a one-way street (that is, heading down). This year, the conviction among debt fund managers is that the spectacular gains of the past year are not likely be replicated.
Given the turbulent state of the financial markets, cash funds can be an effective avenue to deploy funds over a short time while you rethink your investment strategies to suit the changed investment climate.
What are cash funds?
Cash funds are especially ideal for conservative investors whose primary concern is protecting principal and are willing to surrender a few percentage points in return as a trade-off for safety.
These funds invest exclusively in money market instruments such as treasury bills, commercial paper, call money and certificate of deposits. These instruments, issued by government agencies, banks or reputed companies, are usually high on safety and liquidity (usually with a maturity profile of less than a year).
The shorter maturity profile of these funds -- typically less than three months -- insulates them from interest-rate risk. These funds provide limited cheque-writing facilities on 95 per cent of the initial investment, besides a systematic withdrawal facility. These are essentially "no-load" funds, but if you redeem your units in four to seven days, you may be subjected to an exit load.
Where's the difference?
How are cash funds any different from conventional debt funds? Debt funds usually have a longer maturity profile and strive to generate superior returns compared with other fixed -income avenues; the primary focus of cash funds, however, is to preserve capital.
Unlike cash funds, debt funds are prone to interest rate fluctuations and one can witness wild swings in their net asset values, depending on the way interest rates are headed. Cash funds are an ideal short-term investment option, while debt funds are more suited for a medium-term investment horizon, which could be anywhere from six months to three years.
Why you should invest?
Apart from bank deposits, it is the only liquid asset that seeks to preserve capital at all times. All other fixed income investments such as bonds and income funds, are exposed to interest rate fluctuations, and carry the risk of capital erosion till those bonds mature.
There are other reasons to invest in these funds. They are ideal to park your surplus funds, while you make chart out your investment decisions for the long term. And because of their active portfolio management, these funds provide better returns than your bank deposits on a post-tax basis.
Tax deductions on interest income from bank deposits under section 80L of the Income Tax Act have been reduced from Rs 12,000 to Rs 9,000.Tax is also deducted at source on interest income more than Rs 5,000. These funds can even turn into an effective cash management tool for companies. Also, in a scenario where liquidity gets squeezed, cash funds can generate good returns as short-term interest rates tend to rise sharply in such situations.
The budget, however, has taken some sheen off these funds, since dividends and short-term gains will now be taxed as income. However, investors can set off their short-term losses against gains from these funds.
But the strategy to switch to a growth plan to avoid paying dividend tax has little meaning here since cash funds are primarily used as a short-term investment option. Investors can use the systematic withdrawal plans provided by these funds to reduce the tax outflow.
What to look for?
Since the yield differentials between funds are not very significant, you can choose a fund that has an established track record of providing stable and consistent returns. Also keep an eye on fund expenses. Lower expenses help enhance the returns on these funds.
Cash funds have, traditionally, been popular with high net-worth individuals and corporates. That's because to make meaningful returns in rupee terms, you need to make substantial investments in these funds.
Even so, small investors will also find it is more profitable to invest in a cash fund than stash it in a savings account. Allocating a portion of your investible surplus to cash funds will not only inject a shot of liquidity to your portfolio, but also balance your portfolio's overall risk.
