Overnight Funds: Analysing Risk-Return Profiles
Overnight funds are debt mutual funds that invest in securities with a maturity period of one day. These funds are relatively low-risk investments due to the extremely short maturity period of just one day, which seeks to cushion them from interest rate risk and credit risk. While relatively stable, overnight funds are not known for offering a high return potential. The emphasis with these funds is on mitigating the risk to capital and generating a modest, reasonably stable income potential.
In this article, we will discuss the overnight fund risk profile and what to expect from overnight fund returns.
- Table of contents
- Risk-return profiles of overnight funds
- Optimising risk in overnight funds
- Evaluating returns in overnight funds
- FAQs
Risk-return profiles of overnight funds
Overnight funds are structured to prioritise mitigation of risk to principal while ensuring high liquidity. Therefore, while these funds are comparatively less vulnerable to instability in the broader economy, they offer a lower return potential compared to other types of mutual funds, especially equity-oriented plans.
Hence, overnight funds carry a low risk/low return potential profile making them suitable for conservative investors who seek a stable alternative to savings accounts for parking surplus funds for short periods.
However, overnight funds are still theoretically impacted by the following types of risk:
- Interest rate risk:Changes to the central interest rate affect bond performance and yields and can in-turn affect the overnight funds that invest in them. However, since the maturity period is just one day, the potential impact of interest rate changes on overnight funds is minimal compared to that on longer duration funds.
- Credit risk: Again, since the maturity of overnight funds is extremely short, there is negligible risk that the issuers of the securities held by the fund may default on their obligations.
Optimising risk in overnight funds
When assessing risk in overnight funds, investors should the credit quality. The credit quality of the issuers of the underlying securities in the fund's portfolio is an important factor to consider when analysing risk in overnight funds. Investors should look for funds that invest in highly-rated securities with a low risk of default.
Evaluating returns in overnight funds
When evaluating returns in overnight funds, investors should consider several factors. These include:
- Benchmark comparison: Investors should compare the fund's returns with a relevant benchmark, such as the overnight indexed swap (OIS) rate or the repo rate. This will help them determine whether the fund is generating above-average returns.
- Expense ratio: The expense ratio is an important factor to consider when evaluating returns in overnight funds. Investors should look for funds with a low expense ratio, as this can impact the overall returns generated by the fund. However, generally most overnight funds have expense ratios on the lower side.
Conclusion
Overnight funds are low-risk debt funds that offer a relatively stable although modest return potential and high liquidity. While these instruments emphasise minimising the risk to capital, they are not entirely risk-free. Therefore, when analysing risk in overnight funds, investors should consider the credit quality of the securities in the fund's portfolio and the interest rate environment. Also, when evaluating returns in overnight funds, investors must acknowledge that the objective of these schemes is not capital appreciation, but rather mitigating the risk to capital while providing a reasonable income potential via interest payouts.
FAQs
What are the benefits of investing in overnight funds?
The benefits of investing in overnight funds include relatively lower risk to principal, a modest but steady income potential, and high liquidity.
How do overnight funds differ from other types of mutual funds?
Overnight funds differ from other types of mutual funds in that they invest in debt securities with a maturity period of only one day. This makes them relatively cushioned from interest rate risk and credit risk.
What are the risks associated with investing in Overnight Funds?
The risks associated with investing in overnight funds include very low levels of credit risk, interest rate risk, and liquidity risk. However, these risks are relatively insignificant compared to the risks associated with other types of mutual funds.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.