1. How do Liquid Funds work?
Liquid funds aim at providing a high degree of liquidity and safety of capital to the investor. For this reason, the fund manager allocates your money in high-credit quality debt instruments in varying proportions as per the investment mandate of the fund. He ensures that average maturity of the portfolio is up to 3 months. In this way, the returns generated by the fund remain least affected by the overall interest rate fluctuations in the economy. The maturity of the underlying securities is matched to the portfolio maturity to deliver higher returns.
As compared to a regular savings bank account, liquid funds are an efficient way to park surplus funds. These are low- risk havens which provide higher returns as compared to savings bank account. Liquid funds try to emulate the liquidity aspect of a savings bank account by having zero exit loads to give you the flexibility of withdrawal and redemption as per your convenience.
2. Types of Money Market Instruments
As an investor, you should know the various money market instruments:
a. Certificate of Deposit (CD)
These are time deposits like fixed deposits that 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 (CPs)
These are issued by companies and other financial institutions which have a high credit rating. Also known as promissory notes, commercial papers are unsecured instruments which are 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 safest instruments as these are backed by the guarantee of government. The rate of return, also known as 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 who have substantial idle cash and are looking for short-term investment havens. Instead of keeping it in a savings bank account, you may invest that performance incentive which you received recently or some windfall gains in a liquid fund. These 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 time period. In this way, you would save yourself from placing large bets all of a sudden into equity funds.
4. Things to consider as an investor
Basically, the risk in mutual funds relates to fluctuations in its Net Asset Value (NAV). For liquid funds, the 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.
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 realise 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.
f. Tax on Gains
When you invest in debt funds, you earn capital gains which are taxable. The rate of taxation is based on how long you stay invested in a debt fund called as the holding period. A capital gain made during a period of less than 3 years is known as a Short-term Capital Gain (STCG). A capital gain made over a period of 3 years or more is known as Long-term Capital Gains (LTCG).
STCG from debt funds are also added to the investor’s income and taxed according to his income slab. LTCG from debt funds is taxed at the rate of 20% after indexation and 10% without the benefit of indexation.
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 personal details regarding the amount of investment and period of investment
Step 3: Get your e-KYC done in less than 5 minutes
Step 4: Invest in your favourite debt fund from amongst the hand-picked mutual funds
6. Top 5 Liquid Funds in India
While selecting a fund, you need to analyse the fund from different angles. 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 5 liquid funds in India based on the past 1 year returns. Investors may choose the funds based on a different investment horizon like 5 years or 10 years returns. You may include other criteria like financial ratios as well.
|Debt Fund Name||3 year||5 year|
|Aditya Birla Sun Life Medium Term Plan||8.39%||9.13%
|Reliance Credit Risk Fund||7.87%||8.33%|
|Reliance Liquid-Treasury Plan(G)||6.82%||7.32%|
|SBI Magnum Gilt Short Term||8.78%||9.38%
|Aditya Birla Sun Life Short Term Fund||7.83%||8.37%
*The order of funds doesn’t suggest any recommendations. Investors may choose the funds as per their goals. Returns are subject to change.