In search of a low volatility mutual fund

We own a house that we have rented out. The tenants pay a security deposit that we hold as long as the tenants live in our house; the deposit is returned when they move out. I was putting this money in an Ultra Short Term Debt fund thinking I’d need to take the money out any time. (Some context for the uninitiated: Ultra short term debt funds have negligible volatility, so you can redeem them pretty much any time without risking a capital loss. When you invest in more volatile instruments such as equity, you cannot simply take the money out as soon as you want.)

Later, I realised that our regular cash flow is often sufficient to return the deposit without needing to redeem the ultra short term debt investment. Armed with this new bit of information, I started looking for mutual fund schemes that have some equity exposure. I wanted the equity exposure to be low enough to keep the volatility low, even if it meant the returns are a few percentage points lower than an “optimum” investment scheme.

When it comes to mutual fund investments, I like Quantum as an AMC: they don’t take excessive risk chasing returns; they regularly conduct sessions to educate investors. I am also a big fan of Quantum Multi-Asset Fund of Funds. I recommend this fund to everyone who just wants to invest without making a list of goals as long as they can stay invested for a few years. My need aligns perfectly with this criteria: I just need a mutual fund that more or less acts like a bank FD, but gives better returns. (Yes, this is definitely not equivalent to an FD due to the inherent volatility. But I am okay if the fund value goes down a bit.)

But the trouble with choosing a mutual fund scheme is that there are so many of them to choose from! Conservative Hybrid funds seemed like a good fit for my need: they invest mere 10 to 25% in equity and invest the rest of the money in debt instruments. I looked at all available options sorting them by volatility. Of the top few options that had the least volatility, ICICI Prudential Regular Savings fund seemed like a good option. Looking at historical performance, the ICICI fund is actually better than Quantum Multi-Asset! It has given better return while remaining less volatile! This is like a dream combination.

Impressed by the ICICI fund’s historic performance, I moved on to the next step: I looked at the portfolio of the fund to see how it’s getting its returns. Before we get to the ICICI fund’s portfolio, let’s take a quick look at the Quantum fund’s portfolio:

The portfolio of the Mutli-Asset fund holds 42% in Quantum Liquid fund, and about 12% in Quantum Dynamic Bond fund. The rest is invested in equity and gold. I have seen the portfolios of the Quantum Liquid and Dynamic Bond funds; they hold mostly Sovereign debt and a small amount of AAA rated debt. This means the Quantum Multi-Asset fund is taking virtually no credit risk at all.

Now let’s look at the ICICI Regular Savings fund’s portfolio. On 31st December 2020, 82.39% of the portfolio had debt instruments. More than half of the debt portfolio, 57.8% to be precise, was debts rated AA or A! In other words, if you invest ₹1,000 in this fund, ₹476 of that money will be invested in debts rated AA and A. I was not expecting this at all.

So, ICICI Prudential Regular Savings fund is earning attractive return by taking credit risk. But you wouldn’t notice this if you just looked at past performance. The biggest dip you see in the NAV graph is in March 2020 when every fund in India lost value. (If the graph below looks too volatile to you, remember that this fund holds equity along with debt. For a fund with equity exposure, this volatility is incredibly low.)

Think about everything I have said so far. I am saying that this fund is taking a lot of credit risk. I am also saying this fund has very low volatility. How is that possible? Wouldn’t the fund see a credit event, a sharp dip in the NAV, whenever one of these risky debts default? But in the past 8 years, there’s hardly any sharp decline in NAV.

One theory I have is that ICICI is a very good lender: ICICI Bank, ICICI Home Finance, etc make all their money by lending money to customers. With their experience, maybe they have the ability to look beyond credit rating and they know how to identify quality borrowers even if they have a less than perfect credit rating. Maybe.

When it comes to investing my own money, I need to decide which one I trust more: credit ratings or ICICI’s ability to see beyond credit ratings. Neither option is risk free, so I need to choose which risk I am comfortable with. After some deliberation, I have decided that I’d stick with Quantum Multi-Asset Fund for my needs for the following reasons:

• I am not comfortable taking credit risk. Not everyone agrees that credit ratings are accurate or useful, but that’s the best we have today.
• The multi-asset fund is more diversified with some exposure to gold. I just like the idea of having some exposure to gold though I know that some people think gold doesn't add much to a portfolio.
• Supporting responsible AMCs like Quantum is the right thing to do, even when they generate less returns.