Liquid Mutual Funds – Concept, Operations, Suitability, Features, Benefits & more

In this article we will understand all the nuances of liquid mutual funds as well as their potential returns and likely risks.

We will also look at how investors can benefit from these funds and what aspects they should be worried about. 

Not all investment is about investing for several years. Investors may at times look for short term investment avenues as well to park their funds temporarily till the need for it arises. 

In such situation investors may traditionally opt for just keeping the money in savings account with their bank. 

There is however a better investment avenue available in the form of ‘liquid fund’. This fund is a sub-type of debt based mutual funds.

About Liquid Mutual Funds

A liquid mutual fund is an open-ended debt oriented mutual fund.

Liquid Funds invests in specific debt securities that have fixed coupon rate attached to them and whose maturity term is up to 91 days.

Fund managers opt for high quality securities to keep the risk of the fund low.

The securities that these funds invest in include short maturity government securities, commercial paper, treasury bills and other high quality money market instruments.  

The objectives of these funds include:

• Providing high liquidity for its investors
• Providing returns that are better than conventional savings account
• To keep risk levels of the fund very low

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How does Liquid Funds work?

Liquid funds can be invested in through the registered stock markets. 

Unlike other debt mutual funds whose net asset value (NAV) is determined only for days on which the stock market is operational, these funds calculate their NAVs for all days of the year.

True to its name, these funds are open ended to provide high level of liquidity to its investors with no entry or exit load. Investors can redeem funds invested in liquid funds within 24 hours. 

This means investors received proceeds on T+1 day. In case a redemption request is made before 2pm, the NAV applicable for the same day will be considered for redemption. 

This means that the cut-off timing for redemption of these funds is 2pm.

Find details of other Types of Funds here

Features of Liquid Mutual Funds

Here are some of the major Features of Liquid Mutual Funds –

Regulated Returns

These funds earn returns based on the coupon rates of the debt securities that they hold. These returns are fairly defined as these securities are fixed-income instruments. 

These mutual funds earn better returns than the returns earned by money kept in bank savings accounts. 

Low risk

Liquid mutual funds invest in high quality debt instruments that have a high credit rating. This is in line with the fund’s objective of keeping the credit risk of the fund low. 

This means that the risk of the fund defaulting on its redemption requests to its investors is very low.

These mutual funds also have a low interest risk as compared to other mutual funds. This is primarily because of their short duration. 

Interest volatility within a period of 3 months which is the fund’s target duration tends to be low. Thus, the NAV of these funds remains relatively stable.

These two factors keep the overall risk level of these mutual funds low.

High liquidity

Liquid funds invest in securities that have a maturity of under 3 months. This means that their holdings are continuously changing every 3 months.

This short-term duration of the funds makes it highly liquid.

Taxability

Liquid mutual funds are subject to tax when they are redeemed. These funds are held for short periods of time hence their gains are generally taxed as short-term capital gains.

 These gains are added to the investor’s other income and taxed at the applicable slab rate. No tax is deducted at source from the redemption proceeds of these funds.

Who should Invest in Liquid Mutual Funds?

Liquid mutual funds are ideal for short-term investing at low risk levels. They are suitable for the following investors:

1. Investors who have a short-term investing time frame of under 3 months should opt for liquid funds. In case investors intend to hold their investments for longer time periods, they can choose other debt funds or market linked equity funds to earn better returns.
2. These funds suit investors who have a low-risk appetite. Thus, investors looking to create emergency funds or save up for some critical short-term goals can opt for these mutual funds.
3. Investors looking to earn higher returns than returns from savings account with equally low risk can opt for such funds.
4. Investors can use these funds as a pathway to invest in other funds especially equity or hybrid funds. Systematic Transfer Plan (STP) achieves this. Investors invest lumpsum in these funds. Subsequently, the fund house transfers smaller amounts systematically and consistently to other funds of the investor’s choice.

Find details of all types of Debt Funds here

Things to consider while Investing in Liquid Mutual Funds?

Investors must keep certain aspects of liquid funds in mind before investing their money:

Risk

While liquid funds have low risk, they cannot be considered entirely risk free.

Any reduction in the credit rating of the underlying securities in the portfolio can result in a decline in the NAV of the these fund.

Investors must keep this risk, although minimal, in mind before investing. 

Check credit rating

To allay the above risk, investors should assess the credit rating of the debt securities that the particular liquid fund invests in.

Fund performance

Investors can also carry out evaluation of historical performance of various liquid mutual funds to assess which fund has given better returns.

Benefits of investing in Liquid Mutual Funds

Here are the list of Benefits of Liquid Funds Investment –

Advantage of liquidity

Liquid mutual funds are open ended. This means that there is no entry or exit load on investments into or redemptions out of these funds. 

Thus, investors enjoy high liquidity on their investments in liquid funds.

This is in contrast to fixed deposits that carry a premature withdrawal penalty if redeemed before the due date which make them less liquid.

Low risk 

Liquid mutual funds are of short duration (under 3 months) and thus have minimal interest risk.

This is because interest rate volatility is unlikely to have significant impact over such a short duration.

These funds also have low credit risk as they invest only in high quality instruments that have high credit rating.

Better returns than savings

Liquid mutual funds earn better returns that traditional savings account. Investors can thus enjoy the same liquidity and low risk of savings account but earn better returns.

Check out all types of Hybrid Funds here    

Drawbacks of investing in Liquid Mutual Funds

Here are various disadvantages of Liquid Mutual Funds –

Limited return potential

Debt mutual funds typically earn capital growth through duration strategies based on interest rate fluctuations. 

As these mutual funds have short duration, they have negligible opportunity to gain from interest rate volatility.

This limits their return potential when compared to other more lucrative debt mutual funds.

Brokerage and transaction charges

Although these mutual funds do not have any entry load or exit load, they still have costs involved. They are subject to brokerage charges and stamp duty that are levied on their trade. 

No such charges are levied on savings accounts. This additional cost reduces the returns earned from liquid funds.

Liquid Mutual Funds – Conclusion

Liquid mutual funds thus work as a stop-gap measure for investors looking for temporary parking of their funds.

When investors have definitive objectives that are most likely to materialize within a few months, they can opt for these funds. 

For example, if an investor has to make a high down payment for a new house that he intends to book within the next 2 months he can place his funds in a liquid fund till the payments are due. 

This keeps the investor money safe while earning reasonable returns and allowing quick redemption when needed.

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