The mutual fund market in India is vast and varied, with different fund options for every kind of investor. Whether you are an aggressive, conservative or moderate risk-taker, you will undoubtedly find a mutual fund scheme that suits your risk profile. Similarly, you can also choose from funds with varying liquidity levels. Of these, liquid funds are highly popular among investors who prioritise easy exit from the market.
In this article, we discuss the meaning of liquid funds, see how they work and examine the disadvantages of liquid funds.
What are liquid mutual funds?
Liquid funds are mutual funds that invest primarily in debt instruments like Commercial Papers (CPs), Certificates of Deposit (CDs), Treasury Bills (T-bills) and various other short-term government bonds and securities.
The securities that liquid mutual funds invest in typically have a maturity period of 91 days or less. Additionally, these mutual funds are typically open-ended. This makes liquidity one of the most preferred advantages of liquid funds.
Disadvantages of Liquid Mutual Funds
While liquid mutual funds offer many benefits as outlined above, they also have some limitations. The disadvantages of liquid funds are as follows:
- Exposure to certain risks: Liquid funds may carry some risks like inflation risk, interest rate risk and credit risk. You can minimise some of these risks by choosing your mutual fund house and scheme after careful analysis.
- Taxable capital gains: Earlier, liquid funds (and other debt funds) offered indexation benefits on the long-term capital gains. However, with effect from April 1, 2023, the capital gains from liquid funds are added to your total income and taxed according to the slab rate. Also read about the Income Tax Slab rates for FY 2024-25 for taxation.
- No long-term wealth creation potential: Like all short-term investments that focus on the debt market, liquid funds may excel at capital preservation but fall short in terms of capital appreciation.
How liquid mutual funds work?
Liquid mutual funds primarily work towards preserving the capital that investors use to purchase fund units. To achieve this goal, fund managers in charge of handling liquid fund investments choose high-quality debt instruments for the scheme’s portfolio. The investment outlook for such funds is typically short-term — often 91 days or less.
Since the investment duration is so short, liquid funds rarely deliver significant capital gains. This may be a disadvantage of liquid funds for investors who want to create long-term wealth. However, on the upside, such mutual funds may reward investments with regular interest payments.
The reason liquid funds do not offer any significant capital gains is that over the short investment duration involved, the price of the assets may not move very steeply. As a result, the fund value may not show any noteworthy appreciation. That said, it is still possible to earn profits from the redemption of liquid funds if the NAV increases over the investment tenure.
Should you invest in liquid funds
1. Investors with short-term goals
Liquid funds are ideal for those looking to invest for up to 3 months, as they primarily invest in short-maturity securities. For slightly longer durations—around 6 to 12 months—investors may consider ultra-short duration funds for potentially better returns.
2. Bank depositors seeking better flexibility and returns
Investors who typically park their surplus in fixed deposits or savings accounts may benefit more from liquid funds. Unlike fixed deposits, which involve lock-ins and penalties for early withdrawal, liquid funds offer easier access and typically higher returns—often exceeding 5% compared to 3%–4% in savings accounts.
3. Individuals building an emergency fund
Liquid funds are a suitable option for parking contingency or emergency funds. They offer high liquidity, safety, and reasonable returns, making them a dependable choice for handling unforeseen expenses.
4. Investors with idle funds
If you've received a large sum from a bonus, property sale, or inheritance and haven’t decided how to use it, liquid funds are a safe place to temporarily park the money while earning modest returns.
5. Systematic transfer to equity funds
Liquid funds can be used as a holding option before gradually investing in equity via a Systematic Transfer Plan (STP). This approach allows investors to benefit from stable returns in the short term while entering equity markets strategically over time.
Conclusion
Ultimately, depending on your risk tolerance levels and your investment goals, liquid mutual funds may be a suitable addition to your portfolio. This is particularly true if you want to prioritise liquidity. That said, before you make a lump sum investment or start SIP investments in these funds, weigh the advantages and disadvantages of liquid funds thoroughly to make a smart investment decision.
To make your investment journey easier, check out the 1,000+ mutual fund schemes available on the Bajaj Finserv Platform. You can analyse different schemes and compare mutual funds before you decide which one to invest in.
