Does size matter in liquid funds? The biggest is not always the best

The liquid fund category has seen a constant rush of inflows as investors, both retail and institutional, have parked money in these schemes to get better tax-adjusted returns apart from ensuring safety of capital. The liquid fund category manages a little over Rs 4.69 lakh crore across 19.31 lakh folios, with three funds accounting for over 49 per cent of the category asset size.

HDFC Liquid Fund is the asset leader with Rs 1.1 lakh crore, followed by SBI Liquid Fund with Rs 62,794 crore and ICICI Prudential Liquid Fund with Rs 57,565 crore.

Over the past few months, various events have kept the fixed income markets volatile. Risk aversion has increased in the fixed income market. Often, potential investors make the mistake of going with the biggest fund.


But this popular ‘bigger is better’ approach could turn out to be a sub-optimal strategy. Here are reasons why the biggest fund is not always the best.

Asset growth problem
One of the important factors to understand when it comes to choosing a fund is that if a scheme shows too fast asset growth, then this could be a problem in the future. Many a times, investors awash with liquidity join the bandwagon of a particular scheme because of certain factors. The speed of inflows can quickly turn the other way when these expectations are not met, increasing volatility for those investors who stay on.

Let’s look at the top three schemes in this category by asset size. In December 2019, HDFC Liquid Fund had assets of Rs 72,123 crore and this grew over 52 per cent to Rs 1.10 lakh crore in a matter of months. In the same time, SBI Liquid Fund saw 34 per cent growth to touch Rs 62,794 crore asset size while ICICI Prudential Liquid Fund saw marginal increase.

The rush of inflows to one scheme, higher than others, may indicate inflow of volatile money. This money may optically increase the overall fund size, but it can also leave quickly, creating problems for other investors of the scheme, who are not ready for a churn in the portfolio to meet redemptions.

Investment quality
Liquid funds are for keeping investors’ money safe and delivering a better returns than bank savings accounts. For this, credit quality management assumes significance and this should be done by investing predominantly in debt instruments of highest credit quality and sovereign debt instruments. A quick look may show that liquid fund portfolios usually hold 100 per cent AAA-rated instruments, but there is a need to go deeper.

High rated corporate bonds may be there, but not too much. A detailed look at the liquid fund portfolios shows that the biggest fund has 9.3 per cent exposure to corporate debt, ICICI Prudential Liquid Fund 0.9 per cent and SBI Liquid Fund 0.5 per cent.

Here the factor to watch is YTM or yield to maturity. Despite keeping corporate debt low, funds like ICICI Prudential Liquid sport higher YTM (yield to maturity) at around 4.07 per cent, which one of the best among similar-sized peers. SBI Liquid Fund has a YTM of 3.89 per cent and HDFC Liquid Fund 3.63%; meaning the largest scheme by asset size has the lowest YTM.

Returns Radar
Since liquid funds provide a safe option to park short-term money, monthly returns can be an important yardstick to evaluate these funds are doing. On this count, HDFC Liquid Fund generated 0.29 per cent returns in June 2020, which is lower than SBI Liquid Fund’s 0.32% and ICICI Prudential Liquid Fund’s 0.33%. This is not a stray case. A comparison of monthly returns of HDFC Liquid Fund with others for the last three years, the biggest fund has given lower returns than the second biggest in over 50% of the months and exactly the same return in another 37% of times.

ICICI Prudential Liquid Fund, the third-ranked in terms of asset size, has generated a higher returns that the biggest scheme in 73% of the months in last 3 years. This proves that the bigger size of a scheme does not guarantee bigger returns.

Risk ratios
Mutual fund ratios tell you a lot more than just returns. They tell you about how risk is being managed, how volatile is the underlying fund portfolio is etc.

Sharpe ratio: The higher the Sharpe ratio, the better the risk-adjusted return of your mutual fund portfolio. This essentially gives you an idea if your returns are due to smart investment decisions or excessive risk taking. HDFC Liquid Fund has a Sharpe Ratio of 3.95, SBI Liquid Fund 4.19 and ICICI Prudential Liquid Fund 4.43. That again shows the biggest liquid fund portfolio has not delivered the best performance in excess of risk-free return.

Sortino ratio: As investors are mostly concerned about downward volatility, the Sortino ratio gives a more realistic picture of the downside risk ingrained in a fund portfolio. ICICI Prudential Liquid Fund has a Sortino ratio of 6.7 compared with HDFC Liquid Fund’s 6.03 and SBI Liquid Fund’s 5.9. When looking at two similar funds, a rational investor should prefer the one with the higher Sortino ratio, because it means the investment is earning more return per unit of the bad risk it takes on. This ratio is helpful for investors to assess risk in a better manner than simply looking at the returns vis-à-vis total volatility.

Alpha: Alpha gives you an idea of the excess returns that your fund may generate compared with its benchmark. It is seen as the additional value that the fund manager adds or takes away from the return on your portfolio. Higher the alpha, the better it is. While HDFC Liquid Fund has an Alpha of 1.47, SBI Liquid Fund has an Alpha of 1.5 and ICICI Prudential Liquid Fund 1.64. For funds of similar safety and quality, investors would get more bang for their buck if they invest in the fund with a higher alpha.

(Joydeep Sen is author and founder of wiseinvestor.in. Views are his own)