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Liquid Funds : Basics, Things to consider and More

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Liquid funds are a class of debt funds that invest in short-term fixed-interest generating money market instruments. Treasury bills, commercial paper, and so on are some of the examples of the underlying securities in the portfolio of a liquid fund.

This article covers the following:

1. How Do Liquid Funds Work?

The main intention of liquid funds is to provide a high degree of liquidity and safety of the capital for investors. For this reason, the fund manager invests in high-rate debt instruments that mature in just 91 days. The allocated proportions are as per the fund’s investment objective. The fund manager will ensure that the average maturity of the portfolio is three months.

This reduces the sensitivity of fund returns to interest rate movements and makes liquid funds less vulnerable. The fund value does not experience a lot of fluctuations. In addition to this, the maturity of the underlying securities is matched with the maturity of the portfolio. It helps to deliver higher returns.

Liquid funds are an excellent option to park your idle money. These are low-risk havens which offer higher returns than a regular savings bank account. Liquid funds try to emulate the liquidity aspect of a savings bank account. These funds don’t have a lock-in period. You can use liquid funds as a regular savings account and earn higher returns.

2. Types of Money Market Instruments

As a liquid funds investor, you should be aware of the following money market instruments:

a. Certificate of Deposit (CD)
These are term deposits, very similar to fixed deposits. These are offered by scheduled commercial banks. The only difference between FD and CD is that you cannot withdraw CD before the expiry of the term.

b. Commercial Paper (CP)
Commercial papers are issued by companies and other financial institutions that have a high credit rating. Also known as promissory notes, commercial papers are unsecured instruments issued at the discounted rate and redeemed at face value. The difference is the return earned by the investor.

c. Treasury Bills (T-bills)
T-bills are issued by the Government of India to raise money for a short-term of up to 365 days. These are the safe instruments as the sovereign guarantees back them. The rate of return, also known as the risk-free rate, is low on T-bills as compared to all other instruments.

3. Who Should Invest in Liquid Funds?

Liquid funds are meant for those having substantial idle cash and are looking for short-term investment havens. Instead of parking your surplus funds in a savings bank account, you can invest in a liquid fund and earn much higher returns. Performance-based incentives, bonus, and other relevant gains made by selling capital assets are some of the examples for surplus money.

Liquid funds can be used as a medium to invest in equity funds. You may initially invest the money in a liquid fund and then do a systematic transfer to an equity fund of your choice over a specified period.

4. Things to Consider as an Investor

a. Risk
The risk in mutual funds relates to fluctuations in net asset value (NAV). For liquid funds, the NAV doesn’t fluctuate too frequently as the underlying assets mature within 60 days to 91 days, and this prevents the fund’s NAV from getting impacted significantly by the fluctuations in the underlying asset price. However, the fund value might drop suddenly on account of a sudden downgrade of the credit rating of the underlying security. In simple words, liquid funds are not entirely risk-free.

b. Returns
Historically, liquid funds have generated profits in the range of 7% to 9%. It is way higher than the mere 4% returns offered by a savings bank account. Even though the returns on liquid funds are not guaranteed, more often than not, they have delivered positive returns upon redemption.

c. Cost
Liquid funds charge a small fee to manage your investment called expense ratio. SEBI has mandated the upper limit of expense ratio to be 1.05%. Considering the hold till maturity strategy of the fund manager, liquid funds maintain a low expense ratio to offer comparatively higher returns over a short term.

d. Investment Horizon
Liquid funds are ideal to invest surplus cash for a short period say, up to three months. Such short-horizon helps you in realising the full potential of the underlying securities. In case you have a longer investment horizon, say of up to one 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 also help you take out your money quickly in case of emergencies.

f. Tax on Gains
When you invest in debt funds, you earn capital gains, and they are taxable. The rate of taxation depends on how long you stay invested in a debt fund. The duration over which you stay invested is known as the holding period. Since liquid funds are a class of debt funds, gains made in the first three years is known as short-term capital gains (STCG). Capital gains made after three years or more are known as long-term capital gains (LTCG).

STCG from debt funds are added to your overall income and taxed at the income tax slab rate you fall under. LTCG from debt funds is taxable at a flat rate of 20% after indexation. Dividends offered by all mutual funds are added to your overall income and taxed at your income tax slab rate.

5. How to Invest in Liquid Funds?

Investing in liquid funds is made paperless and hassle-free at ClearTax.
Using the following steps, you can start your investment journey:
Step 1: Sign in at cleartax.in.
Step 2: Enter your details, such as the amount and period of investment.
Step 3: Complete your e-KYC; it takes no more than than 5 minutes.
Step 4: Invest in the most suitable fund from amongst our hand-picked mutual funds.

6. Top 5 Liquid Funds in India

While selecting a fund, you need to analyse the fund from different perspectives. 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 five liquid funds in India based on the past year returns. Investors may choose the funds based on a different investment horizon like five years or ten years returns. You may include other criteria such as financial ratios as well.

 

Fund name 1-year return
Aditya Birla Sun Life Liquid Fund Growth 7.49%
Axis Liquid Fund Growth 7.47%
UTI Liquid Fund – Cash Plan Growth 7.47%
ICICI Prudential Liquid Fund Growth 7.40%
L&T Liquid Fund Growth 7.37%

 

*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.