Short Term vs Long Term Mutual Funds - Key Differences (2024)

Things to keep in mind for investing in long-term funds

Before starting a long-term investment in mutual funds, one should consider the following things:

• Investors need to have a proper investment strategy to reach their life goals. They must take their risk-taking capacity into account before formulating one. Furthermore, they need to be disciplined enough to stick to theinvestment strategy.
• A person needs to conduct thorough research to identify the best mutual fund for long-term investment.
• It is advisable to undertake a comparative analysis because it helps in understanding how a certain fund has performed against its benchmark and peers.
• It is important to be patient to earn returns from long-term mutual fund investments.
• Always check the Riskometer tool on our website before investing in a fund. The tool stipulated by SEBI reflects the current risk of the scheme at a given point of time.

Who Might Consider Long-Term Investment Strategies?

Investors with a long-term financial horizon, typically ranging from several years to decades, may consider long-term investment strategies. These investors are often focused on wealth accumulation for major life goals such as retirement, buying a home, or funding their children's education. They are generally willing to endure market volatility, as they have time to ride out market fluctuations and benefit from the power of compounding. Long-term strategies often involve equity-oriented mutual funds, which have historically shown the potential for significant growth over extended periods.

What are short-term mutual funds?

Short-term funds, categorized as debt funds, extend loans to companies for a duration spanning 1 to 3 years. These funds typically focus on reputable companies with a demonstrated history of timely loan repayment and ample cash flows from their business activities to support their borrowing.

How do short-duration funds work?

Let us break down how short-duration funds operate. First, it is crucial to grasp the concept of interest rate risk. This risk refers to how a fund's value reacts to changes in market interest rates. Simply put, longer-term bonds are more sensitive to these fluctuations.

Duration: Think of duration as a measure of a fund's sensitivity to interest rate movements. The higher the duration, the greater the potential for price swings. Short-duration funds, as the name suggests, aim to minimise this risk by primarily investing in securities maturing within 1 to 3 years, as defined by regulatory guidelines.

Investment portfolio: Short-duration funds offer a diversified mix of debt instruments. They might hold:

• Corporate bonds: Issued by companies, these offer potentially higher returns but carry some credit risk.
• Government securities: Considered relatively low risk, these are bonds issued by the government.
• Securitised debt: This involves bundled financial assets like loans or mortgages.
• Money market instruments: These highly liquid assets, like certificates of deposit (CDs) and treasury bills, provide immediate cash flow.

Generating returns: Short-duration funds earn returns in two ways:

• Interest income: The fund receives regular interest payments on the debt instruments it holds.
• Capital gains: When market interest rates fall, existing bonds become more valuable, leading to capital gains. Conversely, rising interest rates cause capital losses. This effect is generally amplified in funds with a higher duration. By strategically managing the fund's duration, managers can attempt to capitalize on favorable interest rate movements.

Short-duration funds offer a balance between potential returns and risk. They provide higher returns compared to ultra-short-term funds while maintaining lower volatility than long-term bond funds. Remember, there's always a trade-off between risk and reward.

Benefits of short-term mutual funds

Short-term mutual funds provide investors with various advantages tailored to their immediate financial needs and risk preferences. These benefits include:

1. Liquidity: Short-term funds boast high liquidity, enabling investors to swiftly access their funds without incurring substantial penalties or losses, making them suitable for emergency expenses or short-term goals.
2. Lower volatility: Compared to long-term funds, short-term funds typically exhibit lower volatility, making them an appealing option for risk-averse investors or those with short-term financial objectives seeking stability in their investments.
3. Flexibility: Investors enjoy the flexibility to reallocate their investments to seize new opportunities without being bound by long-term commitments, offering them the agility to adapt to changing market conditions or investment strategies.
4. Potential for higher yields: Despite their lower risk profile, short-term funds can still yield attractive returns compared to traditional savings accounts or certificates of deposit, providing investors with the potential for higher yields while maintaining a degree of security.

Things to keep in mind before investing in short-term funds

• Investors who don't mind taking on some interest rate risk in exchange for better returns can start with short-duration funds.
• In general, these funds produce reliable short-term incomes. However, if interest rates unexpectedly fluctuate, fund prices may experience significant volatility.
• When a short-term fund is redeemed after being held for more than three years, the benefit of indexation kicks in, resulting in lower taxes for investors.

Who Might Consider Short-Term Investment Strategies?

Short-term investment strategies are suitable for investors with immediate or near-future financial needs. These could include building an emergency fund, saving for a short-term goal like a vacation, or having cash readily available for unforeseen expenses. Such investors prioritise capital preservation and liquidity over long-term growth. They often choose debt funds or money market funds, which are less volatile and offer quicker access to funds. Short-term strategies focus on minimising risk and maintaining the value of invested capital rather than significant wealth appreciation.

Taxability of short-term funds

Short-term funds are particularly suitable for investors who prioritise safeguarding their capital and earning interest from the debt portfolio.

Regarding taxation, under the Budget 2020 amendments, dividends earned on mutual funds are added to the total income and taxed according to the investor's income tax slab. The taxation of these debt funds is as follows:

• If the holding period of the debt investment is less than 36 months, it is taxed based on the individual's income tax slab and categorised as a short-term investment.
• If the holding period of the debt investment exceeds 36 months, it is considered a long-term investment and taxed at 20% with indexation benefits.

Short-term mutual funds offer the option of a growth plan, where the tax treatment mirrors that of a bank fixed deposit. Alternatively, investors can choose dividend options, where the income from the investment is exempt from tax.

Conclusion

To sum up, people need to check their financial goals, and risk appetites and choose long-term or short-term mutual funds accordingly. Financial experts advise people to start investing as soon as possible as it helps to build a substantial corpus by the time one retires.To get more information on mutual funds and start your investment journey, download the Bajaj Finance app. The app also helps you with tools to manage your investments and hence is a one-stop solution to your investment needs.

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