Liquid funds invest in short-term high-credit quality fixed income earning money market instruments like a certificate of deposit, treasury bills, commercial paper, etc.
This article covers the following:
Liquid funds are mutual fund schemes that invest their corpus in financial instruments such as Bank fixed deposits, Treasury Bills, Commercial Paper and other debt securities with maturities up to 90 days. The NAV (Net Asset Value) of the funds is calculated for 365 days, unlike other debt mutual funds where NAV is computed for business days only.
Liquid Funds have no restrictions of a lock-in period. These funds allow withdrawals to be processed within 24 hours on business days. So for all transactions received within a cut of time (say 2:00 pm) where money is also realized within the cut-off time, the units are allotted as per previous day NAV. Liquid funds have the lowest interest risk associated with all the class of debt funds. This is because they primarily invest in fixed income securities with short maturity. Another notable benefit of liquid funds is that they do not have any entry or exit load.
2. Who should invest in liquid funds
Since these funds provide liquidity and not high returns, it is advised that investors looking to park their idle money should consider liquid funds as a viable option. However, one should be varied enough not to put one’s emergency corpus in liquid funds since liquid funds provide redemption in such a way that money is the credit on your account only the next day. So parking all the emergency fund in liquid funds is not a good practice.
Ideally, liquid funds should be utilized to achieve your short-term objectives. Since some funds generate around 8% to 9% returns, they should definitely be preferred over savings account which provides 4% to 6% returns. In fact, the nature of their portfolio allocation is such that there is not much risk of volatility or default associated with liquid funds provided one invests in high rated (AAA or AA) liquid funds.
3. Things to consider as an investor
a. Fund Objectives
Liquid funds are least risky of all the debt funds. The Net NAV doesn’t fluctuate too frequently because the underlying assets mature within 60-91 days. This somehow prevents the fund NAV from getting impacted too much by the underlying asset price fluctuations. However, there might be a chance of a sudden drop in NAV in case of a sudden downgrade of the credit rating of the underlying security. To put it simply, liquid funds are not completely risk-free.
b. Expected Returns
Historically, liquid funds have been found to generate returns in the range of 7%-9%. It is way higher than the mere 4% returns obtained on savings bank account. Even though the returns on liquid funds are not guaranteed, in most of the cases they have delivered positive returns upon redemption.
Liquid funds charge a fee to manage your money called an expense ratio. Till now SEBI had mandated the upper limit of expense ratio to be 2.25%. Considering the hold till maturity strategy of the fund manager, liquid funds maintain a lower expense ratio to provide relatively higher returns over a short period of time.
d. Investment Horizon
Liquid funds are exclusively meant to invest surplus cash over a very short period of time say up to 3 months. Such a short horizon helps to realize the full potential of the underlying securities. In case you have a longer investment horizon of up to 1 year, then you may consider investing in ultra-short term funds to get relatively higher returns.
e. Financial Goals
If you want to create an emergency fund, then liquid funds can prove to be very useful. In addition to receiving higher returns, these will help you to take out your money easily in case of emergencies.
4. How to evaluate Liquid funds?
a. Fund returns
Fund performance plays a crucial role in the selection of appropriate funds. You may seek funds which have delivered consistent returns over different time horizons. Choose funds which have outperformed their benchmark and peer funds in a consistent manner across say 3, 5 and 10 years. However, remember to analyze the fund performance which matches your investment horizon to get relevant results.
b. Fund history
History of the fund house becomes an important criterion towards fund selection. Fund houses which have a strong history of consistent performance in the investment domain may be trusted to stay resilient during slumps and market rally. A fund house that has a consistent track record for at least say 5 to 10 years is the one that you may go for.
c. Expense ratio
Expense ratio shows the operating efficiency of a mutual fund scheme. It indicates how much of your invested amount is being used to manage expenses of the fund. A lower expense ratio translates into higher take-home returns for the investor. Choose a fund with a lower expense ratio which can give you superior performance.
d. Financial ratios
In addition to using plain vanilla returns, there is a range of financial ratios available which can be used to analyze the performance of the fund from different angles. You may employ tools like standard deviation, Sharpe ratio, alpha and beta to examine the risk-adjusted returns and relative riskiness of a fund. A fund had higher standard deviation and beta is riskier than a fund with lower beta and standard deviation. Look for funds with a higher Sharpe ratio which means it gives higher returns on every additional unit of risk taken.
5. Top 10 Liquid funds in India
While selecting a fund, you need to analyze the fund in a holistic manner. There are various quantitative and qualitative parameters which can be used to arrive at the best liquid funds as per your requirements. Additionally, you need to keep your financial goals, risk appetite and investment horizon in mind.The following table represents the top 10 liquid funds in India based on the past 1 year returns. Investors may choose the funds based on a different investment horizon like 3 years or 10 years returns. You may include other criteria like financial ratios as well.
*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.
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