A reader asks, “Sir, a friend recommended ICICI Prudential Short Term Fund is a suitable choice for my need which is three years away. The AMC website says the fund can be used for durations above six months. Can you please let me know if this is true and if I can proceed with the investment?”
ICICI Prudential Short Term Fund is “an open-ended short-term debt scheme investing in instruments such that the Macaulay duration of the portfolio is between 1 Year and 3 Years.”
What does this mean? If we consider the fund portfolio a composite bond, it will take anywhere between 1 to 3 years to recoup your investment (at the price you purchased). Read more:Why you need to worry about duration if your mutual funds invest in bonds.
This is a crude definition and assumes the bond portfolio does not change during the time you invest in the fund, which is impractical. The weighted average tenure of the bonds in the portfolio will be higher than the Macaulay duration. Sometimes it will be just a few months more and sometimes several years more.
The higher the Macaulay duration and higher the average portfolio maturity higher will be the volatility in the NAV. The modified duration is another measure of NAV volatility (see the above link on duration for an explanation).
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For example, the current Macaulay duration of the fund is about 2.3 years, while the average portfolio maturity is about six years! As one can see from the chart below, the weight of long term bonds has increased in the portfolio, but the Macaulay duration is still low. This is because Macaulay duration factors in interest payments made. So higher the tenure of the bond, the higher the difference between bond tenure and Macaulay duration. One can play around with this bond duration calculator to see how this works.
So we can only understand this in relative terms. The current Macaulay duration of ICICI Money Market Fund is about 0.32 years, with an average portfolio maturity of 0.34 years. The Modified Duration is 0.3191 years. So we can expect ICICI Prudential Short Term Fund to be a bit more volatile than the Money Market Fund.
Volatile here means the fund will react strongly to bond market supply vs demand forces. Some people call this interest rate risk. While this is not entirely incorrect, depending on macro-economic factors and special circ*mstances, different bond market segments will have different buying vs selling pressures.
We recommend investors only look at the average portfolio maturity and not the Macaulay or Modified duration for estimating NAV volatility.
Why? The current Macaulay duration of ICICI Gilt Fund is about 1.9354 years, with an average portfolio maturity of 10.13 years. The Modified duration is 1.93 years. If we considered the Macaulay or Modified durations, we might be led to the incorrect assumption that the gilt fund is currently as volatile as the short-term fund.
The five-year rolling returns of the three funds are compared below. We can see that the short-term fund has volatility in between that of a gilt fund and a money market fund.
To determine a suitable duration of investment, the Macaulay duration can be used if it is governed by SEBI rules to be range-bound. In this case, it is 1-3 years. So we recommend using it for durations much higher than three years. At least five years or more, preferably six years or more (2 x3 years).
For funds not governed by range-bound Macaulay durations, e.g. liquid funds, corporate bond funds, gilt funds etc., the average portfolio maturity can be used to determine volatility and investment duration.
Also, it must be kept in mind that ICICI Prudential Short Term Fund invests a significant portion of its portfolio in corporate bonds. This is susceptible to credit rating downgrades and defaults. It is important not to be swayed by the dominant AAA rating below. That is subject to change.
Such a credit rating profile may only be suitable for experienced investors.
In summary, never go by any AMCs recommendation of suitable investment duration. Study past factsheets to find out the credit rating profile of the portfolio and its average maturity. For your need which is three years away, a money market fund is more suitable than a short-term fund. For recommendations, see: Handpicked List of Mutual Funds Jul-Sep 2022 (PlumbLine).
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