Liquid Funds belongs to the category of debt mutual funds that invest in short-term securities like treasury bills, certificate of deposits, commercial papers, term deposits etc. with a residual maturity period of up to 91 days. Liquid funds can be considered as an alternative to your saving bank account or short-term fixed deposit. They generate steady returns and are very likely to preserve your principal amount.
Benefits of Liquid Funds
- High Liquidity- Liquid funds provide higher liquidity. You can easily redeem your funds. The processing takes only 24 hours maximum.
- No lock-in period- Liquid funds do not have a lock-in period. Whether you have invested for a year, month or a week, you can redeem your money anytime without any exit load. However, you have to pay a minor charge ranging between 0.0045—0.0070% if redeemed within 7 days of investment.
- Low Risk- These funds invest in low-risk money market instruments offered by Government, RBI and other highly rated companies. So, the chance of payment default by these agencies is less, and as the investment is for a shorter duration, the risk associated with it is also very less.
- Higher returns- Liquid funds usually give returns in the range of 5-7% which is better than regular savings account interest and more or less similar to bank fixed deposits. But a problem with fixed deposits is that they have a lock-in period.
Who Should Invest in Liquid Funds?
- Liquid funds are ideal for those who want to park their idle money for short-term and earn superior returns on them than bank deposits.
- Those who want to create a savings or emergency fund.
- Those who have cash in hand to fulfil a near term goal say in the next 4-5 months like children’s marriage, going for a trip, buying a car etc.
- If you fall in the higher tax slabs, liquid funds can prove to be more tax-efficient as they add up to higher after-tax returns than a savings account and fixed deposits.
Things to consider while investing in liquid funds
- Star Ratings– Don’t fall into the trap of Fund’s star ratings and don’t chase after returns. These ratings are based on the previous returns. Let’s take the case of NBFCs like IL&FS and DHFL. The returns of most of the 4 or 5-star rated funds invested in these NBFCs become negative after the crisis.
- Fund House– Always choose a fund house whose Asset Under Management (AUM) is more. In the case of liquid funds, the size of the fund matters. Retail investors like us invest a very small amount in lakhs, but most big investors invest a huge amount in crores in liquid funds. Due to some reasons, if 2 or 3 big investors withdraw their money, it will negatively impact the NAV. But if the AUM is large, then it will have a less impact on the NAV. So, the higher the AUM, the better it is.
- Holdings- Always choose a fund which has more holdings. It should be at least 25-30. The concentration risk is more in fewer holdings. But if the holdings are more, and if any instrument defaults, then other instruments compensate the loss. So, the higher the holdings, the better it is.
- Ratings of Instruments– When you choose funds and see holdings, always check how it is rated. The commercial papers of private companies are rated like A+, AAA etc. Choose the Fund which has invested in high rated commercial papers. Also, check how much amount is invested in T-bills, CDs and CPs. The maximum allocation should be in T-bills and CPs of government and its agencies. The returns are less in these instruments, but the money is safe.
Are Liquid Funds risk-free?
Liquid Funds are not risk-free, but they are a low-risk category of mutual funds. Two types of risks are associated with liquid mutual funds, i.e., credit risk and interest rate risk. Both the risks are low for liquid funds as they are short-term instruments.
Tax Implications of Liquid Funds
- If the Fund’s duration is less than 3 years, then short term capital gain tax will be applicable as per your tax bracket.
- If the Fund’s duration is more than 3 years, long term capital gain tax will be applicable. The current tax rate is 20% of profit with indexation (price adjusted to inflation).
Lastly, the minimum investment various across different fund houses. It may be Rs 1000, Rs 2000 or Rs 5000 depends upon the fund houses. But there is no maximum limit.
Note: Resident Individual investor can redeem units up to Rs. 50,000/- or 90% of the latest value of the investment whichever is lower, through online mechanism under Insta Access Facility provided by various Liquid Fund (s) subject to SEBI Regulations. The limit is applicable per day, per scheme, per investor.
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