Open-ended target maturity debt funds are an excellent choice

A few months ago, I made a blog post arguing that you should avoid volatility in debt investments. To summarise, these were my arguments:

1. When your financial goal is reached, all your money will be in debt investments. If there’s volatility in your debt portfolio, you might end up losing money. (Assumption here is that you don’t have flexibility around when you need to spend this money.)
2. It’s fine to invest in volatile debt investments as long as you’re willing to manage the volatility. For example, gradually moving money from your volatile debt investments into more stable debt investments. While doable, this is more work because you’re now rebalancing between 3 asset classes (equity, high volatility debt, and low volatility debt) instead of 2.

As a follow-up to the 2nd point, I made another blog post where I compared the performance of a volatile debt fund with a liquid fund. While you do earn a little bit more on average — say 8% instead of 7% — the volatility can cause a loss if you don’t effectively manage the risk. I recommended avoiding volatility because that’s a good tradeoff for many people. Simple is better than complex.

Recently I learned that there are some open-ended target maturity debt funds in the market. To make sense of these funds, we must first understand what “open-ended” and “target maturity” mean.

“Target maturity” debt funds invest in bonds that mature at a predetermined time. As an example, you can invest in a fund that matures in June 2026 if your financial goal is within a few months from June 2026. This fund will be volatile in the early years, but you will not be affected if you stay invested till maturity. The fund’s volatility will keep on reducing as we approach the maturity date because interest rate risk keeps reducing until it becomes nil on the maturity date. (Remember that credit risk does not reduce, so this isn’t entirely risk free.)

Fixed maturity funds have usually been closed-ended, meaning you can only invest in them during their NFO period; you can exit only at maturity. (You can buy/sell in the secondary market, but that’s not always practical.) Closed-ended funds are too inflexible to use for goal-based investing because rebalancing between debt and equity will be very hard. You want to be able to buy and sell your assets freely. In other words, you want open-ended schemes that allow you to buy and sell whenever you like.

Now that we know what “open-ended” and “target maturity” mean, let’s look at why open-ended fixed maturity debt funds are perfect for goal-based investing.

• Though the debt investment is volatile in the beginning, its volatility keeps reducing over time. This means that you don’t need to manage interest rate risk (which causes volatility), but the scheme automatically manages volatility. The only requirement is that you need to hold the investment till maturity.
• Because high duration debt usually provides a little bit more return on average, you also end up making a little bit more return than investing in a liquid fund throughout the investment period. The difference is likely not huge, but this is free money since you’re getting this additional return without increasing risk or complexity.

Right now, there are open-ended fixed maturity funds that mature in 2023, 2025, 2026, 2027, 2028, 2030, and 2031! It’s possible that AMCs will launch similar funds that mature in other years as well. You may just have to wait for some time before an AMC introduces a fund that matures at a time suitable for you.

Choose a fund that matures very close to your goal

• Do invest in a fund that matures no more than a few months before your goal date.
• Do not invest in a fund that matures much before your goal date. You’ll pay taxes on the maturity proceeds and park the money in a safe place (say a bank deposit or a liquid debt fund). This parked money will have short term capital gain that’s taxed at a higher rate.
• Do not invest in a fund that matures much after your goal. You will need to exit the investment before maturity. While open-ended schemes allow that, you’ll be exposed to volatility at the time of exit.

Reasons why I exited my gold investments

There’s a phrase that’s commonly used: “the straw that broke the camel’s back”. You keep adding straws one by one on the back of a camel and the weight keeps increasing. At one point, you add a certain piece of straw and the load becomes too much for the camel to bear. That last straw is the “one that broke the camel’s back”. Anyone that blames just that one straw is obviously focusing too narrowly and missing the bigger picture.

When I made a blog post about exiting gold, I stated gold’s inconsistent appreciation as the reason. Truth to be told, that was not the only reason. There were other reasons that were already pushing me towards exiting gold. Inconsistent appreciation was the metaphorical last straw. Here is the list of all the reasons.

• Gold is a passive asset (also known as store of value). Gold appreciates in value only when others are willing to pay us a higher price for the same gold. This is qualitatively different from equity and debt. Equity appreciates because businesses create wealth; debt appreciates because we lend capital and earn interest. The passiveness of gold made me uncomfortable.
• This is probably leaning more towards paranoia than skepticism, but I am also afraid of some scientific breakthrough making mining/refining gold cheap. Say, for example, harvesting gold from asteroids. They say aluminium used to be expensive until technology made it super cheap. How can we be sure that something like that will not happen to gold?
• Triggered by these concerns, I set out to see for myself what gold adds to a portfolio. 15% was the maximum I was willing to allocate to gold. At 15% allocation, I didn’t see that much of an improvement to the portfolio (analysis spreadsheet). There was perceptible difference for sure, but the difference wasn’t significant enough to overcome the other concerns.
• Finally, the long periods of stagnation or depreciation that I highlighted in my previous blog post.

To be clear, my stance is not that gold is a bad investment. I am only saying that I personally am not comfortable investing in gold. If you like gold, go ahead and invest in it. But know beforehand why you are adding gold. If you want to reap the benefits when gold is outperforming, you need the conviction to stay invested when gold is underperforming. If you don’t know what gold is adding to your portfolio, it’s hard to remain calm when gold is having a few bad years.

My DIY investment journey: an interim update

What does the journey of a typical DIY investor look like? (DIY is short for ‘do it yourself’ — rather than taking help from advisors or readymade tools.) I don’t know how much I can generalise, but my DIY journey has been filled with mistakes and revelations.

When I started goal based investing early in 2020, I used Kuvera’s goal planner. In fact, before Kuvera I hadn’t even heard of the phrase “goal based investing”. Within a few months, I decided to switch to DIY investing. I decided to take full control of the investments because I was just not comfortable investing without knowing the full glide path in advance. I drafted an elaborate plan using a spreadsheet with my own glide path for every financial goal I had.

Mistakes: an essential ingredient for progress?

It’s been around 8 months since then. In this short time, I have found and corrected an innumerable number of mistakes in my plan/spreadsheet. Mistakes such as not accounting for taxes. Or having too much exposure to equity. Or getting cell addresses wrong in spreadsheet formulas. Many, many such mistakes, big and small.

Some mistakes were annoying but harmless. Some were outright dangerous with a potential to cause capital loss. Despite the bumpy ride, I am pleased with my journey so far. If I had to start all over again, I’ll happily retrace the same path.

With months spent on tweaking and tuning, my investment planning spreadsheet has become sophisticated. Within the spreadsheet, I have a mini “dashboard” that shows informational and actionable data such as how much I am falling short compared expected corpus size, whether the asset allocation is out of whack, how much money to move to reset asset allocation, etc.

Asset allocation mistake

One big mistake I made was to allocate too much to equity in the initial year. Not because I wanted to, but because I made a mistake in the math. I have tweaked the plan to compensate for that mistake, but now I see that I’ll never have to buy more equity if everything goes according to plan.

The first column in the screenshot below is the year, and the second column shows the [truncated] amount I’ll be investing into equity. You’ll notice that for every year except 2020, the number is negative. This means I’ll keep selling some equity every year for 20+ years and might never have to buy more equity.

Screenshot of my spreadsheet showing that I only have outflows from equity investments throughout the rest of my investment horizon

Fixed income, not equity, is the bigger pie

Another interesting thing I noticed was how little I should allocate to equity. I am an irrationally greedy investor who wants to put as much money as possible in equity. But turns out, I should allocate less than 25% to equity in most of the years! To be honest, I am a little disappointed. I wanted to experience the violent volatility of equity, but my plan says I should invest most of the money in fixed income instead! 🙁

Screenshot of my spreadsheet showing target asset allocation. The first column is year, second column shows equity %, and the third column shows fixed income %. The big drop in equity allocation from 2020 to 2021 is not intentional. I overallocated to equities in 2020 by mistake.

This was an interesting revelation for me. This means a few things:

• I didn’t know I wanted the thrill of equity investments. Without this exercise, I wouldn’t have known that about myself.
• I pretty much don’t have to think about the choice of equity mutual funds to invest in. Redeeming equity and buying fixed income will be the usual thing I’ll be doing every year. (There will still be times when I have to buy equity for rebalancing. But I won’t have regular equity SIPs.)
• Until now, I didn’t think much about my debt portfolio because debt was a “boring” investment. My debt portfolio is also very simple with just one ultra short term debt fund. But now, I think I should pay more attention and look for opportunities to optimise the debt portfolio.
• A clarification on the previous point: complexity in a portfolio is not good, and I am well aware of that. However, I am not very comfortable leaving a big chunk of the money in one debt fund. This exposes me to fund manager/AMC risk, for example. Having more funds will help me sleep better, I think.
• Investing in more debt categories than one is also an intriguing option. I’m thinking about the options. I’ll post my plans in future blog posts as the plan solidifies.

Do longer duration debt funds give higher returns than liquid funds?

I started goal-based investing in 2020; a little more than a year ago. I invest in Kuvera’s recommended portfolio with some tweaks. One of the tweaks is to invest in an Ultra Short Term debt fund rather than a Liquid fund as recommended by Kuvera. In this post, I am going to describe how I made that decision and review whether that was a sensible decision.

Why I chose Ultra Short Term debt funds?

Back in early 2020, I was looking at many debt fund options. I was a naïve newbie investor back then, so I didn’t pay much attention to anything beyond returns. I noticed that Liquid funds were giving around 6% return while Ultra Short Term funds were giving around 8% return. Other categories had a longer duration, but the returns were around 8 or 9% only. I was told that longer duration means higher risk. I didn’t know why the risk was higher, but I avoided investing in any duration longer than Ultra Short because there was no reward (higher return) justifying the higher risk.

Basically, I chose Ultra Short over Liquid because Ultra Short gave better return than Liquid. (This was dumb; you please don’t make this mistake!)

Dabbling with different debt fund categories

Though I had decided to invest in Ultra Short Term debt, my search for an “optimal” debt fund never stopped. I kept looking at many options, including Credit Risk, Short Duration, Medium Duration, Equity Arbitrage, and even Conservative Hybrid. I started getting convincing answers only after I learned to look at rolling return graphs to get a summary view of historical returns over many years. (Huge Thanks to RupeeVest.com for making rolling return data available for free!)

With rolling return graphs, I am able to see fund behaviour more clearly than the NAV graphs that everyone shows. Let’s compare the historic returns (1 year rolling returns) of an average liquid fund (Edelweiss Liquid Fund) with a high-performing medium duration fund (SBI Magnum Medium Duration Fund).

1 year rolling returns of SBI Medium Duration fund (green line) vs Edelweiss Liquid fund (purple line)

Two things stand out immediately:

• The returns from the liquid fund is more predictable (less volatility)
• While the medium duration fund has given higher returns at times, it has also given less returns than the liquid funds.

If (i) you’d be holding your debt investments for a few years, and (ii) you don’t intend to redeem and reinvest based on interest rate movement, the returns you’d get from a liquid fund is going to be similar to what you would get from the medium duration fund. In other words, the higher risk or higher volatility may not really translate into higher returns!

We observe the same pattern when comparing with another high performing medium duration fund. The HDFC medium duration fund has less volatility than the SBI one, but it’s still considerably more volatile than the liquid fund. The average returns are still not considerably better than the liquid fund.

1 year rolling returns of HDFC Medium Duration fund (blue line) vs Edelweiss Liquid fund (purple line)

So, what’s the takeaway here?

Longer duration debt definitely gives you more volatility, but the returns may not really justify the added volatility.

But what about Ultra Short Term?

After seeing this data, I had to know if I have made a mistake by choosing Ultra Short Term fund instead of Liquid. So I added my favourite Ultra Short Term fund to the graph:

1 year rolling returns of HDFC Medium Duration fund (blue line) vs Edelweiss Liquid fund (purple line) vs L&T Ultra Short Term fund (teal line)

1 year rolling returns of Edelweiss Liquid fund (purple line) vs L&T Ultra Short Term fund (teal line)

We see the same pattern again. The return lines are interwoven and the average is likely the same for both lines. My decision to invest in ultra short term funds is not particularly bad, since the volatility isn’t that high. But I may not really be getting higher returns as I had hoped.

Are longer duration debt funds useless then?

Of course not. They are useful if you know how to use them. Longer duration debt funds give opportunities to investors who are willing to buy and sell tactically to benefit from interest rate movements. You can earn a good return if you can sell your longer duration funds when the interest rate goes down. You need to watch the market and actively buy and sell.

But if you’re like me, and just want to hold the funds until your goal date, longer duration debt increases the likelihood of capital loss without increasing your returns by much.

Save for everything all the time: an ‘EMI life’

I started goal-based investing only last year. A full 15 years after I started working full-time. This is a late start for sure, but better late than never.

I jotted down a total of 19 financial goals and made a plan for how much I’ll invest towards each goal. I was feeling proud about this for a while, but soon realised that this plan resulted in a bad liquidity crunch for me. I pretty much invested everything I was earning and I didn’t have much money left for even semi-essential day-to-day expenses. I tweaked the plan to improve the cash flow, but I was still falling short. Then I realised that big ticket short-term expenses were the biggest shock to the system, and I started saving for some of these expenses.

While I saved for some expenses, others were simply forgotten. I was saving for my 2 children’s school fees, but I had failed to save for the medical expenses for the birth of my 3rd child. Nor was I saving for the school admission fee for my 3rd child. My calculations show that I need to step up my savings significantly to meet these school expenses. I realised that the plans that I was so proud of were severely incomplete.

Saving for children’s school expenses significantly increased the amount of money I had to keep aside every month, but I was still able to remain afloat. Today I was thinking about our old car and it dawned on me that we’ll need to replace this car in a few years. I need to start yet another monthly saving to fund the car purchase when the time comes! 😟

Thinking more, I realised that I should be saving for everything all the time! When should I start saving for a new car? As soon as I have paid off the current car loan. When should I start saving for my child’s 2022-23 school fees? As soon as I have paid the 2021-22 school fees. Sort of like having to pay half a dozen EMIs indefinitely. If I don’t to do that, I am going to be unprepared when these big ticket expenses do inevitably come.

•••

One of the simplest but very effective ideas for behaviour change is to start small. Just do one thing right, or change a tiny part of your day for the better. As time goes by, that change will spill over to other parts of your day and your life improves beyond the initial change that you made.

I am seeing such a change in the way I manage money. What started as a plan that covers my crucial long-term financial goals has spilled over to more and more of my less crucial but still important goals/expenses.

The revelation about having to buy a car in a few years came today. I have entered the goal into Kuvera without a plan for where the money will come from. This is definitely overwhelming and I am frustrated that expenses are piling up. At the same time, a part of me understands that uncovering such holes in my plan is a good thing. The more holes I uncover, the more holes I can plug. The more holes I plug, the fewer financial shocks our family will have to endure.

Like they say, the more you sweat in peace, the less you bleed in war. I intend to win the ‘personal finance’ war without bleeding (much).