Liquidity in mutual funds refers to the period and cost involved in converting the mutual fund investments into cash. If a mutual fund is highly liquid, it would be easier to sell the units and realise cash.
Liquidity in mutual funds is an important factor for mutual fund investors as it defines the ultimate profit they will get. In this article, we explain what is liquidity mutual funds and how it impacts your investment decisions.
What is liquidity?
Liquidity refers to how quickly and cost-effectively an asset can be converted into cash. The more liquid an asset is, the easier and faster it is to access its value. In contrast, assets with lower liquidity may take longer to sell and may involve higher transaction costs.
Cash is considered the most liquid asset because it can be readily used or exchanged with minimal effort. On the other hand, physical assets like real estate, artwork, or collectibles are relatively illiquid, as converting them into cash takes more time and effort.
For example, imagine someone wants to buy a branded outfit worth Rs. 8,000. If they have cash, the transaction is immediate and straightforward. But if they only have a painting worth Rs. 8,000, they would first need to find a buyer, sell the artwork, and then use the cash to make the purchase. This extra step illustrates the lower liquidity of tangible assets compared to cash.
What is liquidity in mutual funds?
Mutual funds are investment instruments that pool investors’ money and invest it in a diversified range of assets, such as stocks and bonds. Liquidity in mutual funds is the time it takes to sell the mutual fund units and realise cash, along with the costs that an investor needs to cover while converting the units into money. Unlike stocks, selling mutual fund units involves paying a fee called an exit load.
Liquidity in mutual funds depends on the included assets. For example, if a mutual fund invests most of the pooled money into PSU stocks and government bonds, it would have higher liquidity as the demand for such MFs is higher. On the other hand, a mutual fund with a majority of investments in penny stocks or junk bonds would have lower liquidity as MFs are risky in nature and have a lower demand.
How does liquidity affect investment decisions?
Here is how mutual fund liquidity affects investment decisions:
- Investment horizon: If you want to invest for the short term, highly liquid assets are ideal as they sell faster. If the investment horizon is long-term, an added liquidity focus is insignificant as investors can wait in case of a bearish market trend.
- Risk management: If you have a lower risk appetite, highly liquid assets can be ideal, as they carry lower risk due to their high demand. Assets with low liquidity are considered riskier as they are prone to higher volatility and costs.
- Emergency situation: Assets with high liquidity are easier to sell, making them suitable for emergencies. Less liquid assets take more time to sell, which may be problematic when cash is needed during an emergency.
- Market conditions: Liquidity is often affected by overall market sentiment. In periods of uncertainty or volatility, it can become more difficult to sell assets quickly, as demand may drop, and buyers may be hesitant.
How do AMCs ensure liquidity?
Asset management companies maintain a cash reserve through cash or cash-equivalent assets, such as treasury bills, and by maintaining a balance of highly liquid assets, such as cash, government securities, and large-cap stocks. Furthermore, AMCs also reinvest dividends and interest for higher liquidity.
Types of funds more prone to liquidity risk
Liquidity risk is when investors cannot convert their investments into cash. Here are the types of mutual funds more prone to liquidity risk:
- Close-ended credit-risk funds, as they invest in debt securities with a higher risk of default.
- Mutual funds with a higher asset allocation in low-quality or junk bonds.
What are different types of liquidity?
There are two types of liquidity:
Market liquidity
Market liquidity refers to the total number of buyers and sellers available in the market to allow buy-and-sell transactions. For example, stocks have higher liquidity than real estate, as the stock market has more buyers and sellers.
Accounting liquidity
Accounting liquidity is the ease with which a company or an individual can cover financial or debt obligations by liquidating an asset. For example, a company with more liquid assets can meet its debt obligations faster by liquidating the assets.
Five things to know about liquidity in mutual funds
Here are the five things you must know about liquidity in MFs.
- Mutual funds with high liquidity are less risky.
- If a mutual fund has invested in less commonly traded securities, it will be less liquid.
- Fund managers are mostly responsible for ensuring liquidity in mutual funds.
- Exiting mutual funds carry an exit load, which can decrease liquidity
- Mutual funds with high liquidity are ideal for short-term investing.
Role of liquidity in investments
Here is the role mutual fund liquidity plays in investments:
Liquidity helps accelerate transactions
Highly liquid assets see great demand, which accelerates transactions and helps realise cash faster.
Liquidity eases the selling process
It becomes comparatively easy to sell highly liquid assets as numerous buyers are available to buy them instantly.
Liquidity is a greatly overlooked attribute
Liquidity is a greatly overlooked attribute. When analysed, it can help you compare mutual funds and invest according to your investment goals.
Liquid assets maintain their value
Liquid assets maintain their value in the short term as there are numerous buyers and sellers for them, resulting in quick cash conversion with no loss in value.
How can investors avoid the risk due to liquidity?
Investors can avoid the risk of liquidity in mutual funds by extensively analysing the mutual fund scheme and understanding where the AMC is investing the money. If you are investing in close-ended mutual funds, you should ensure that the fund’s risk profile aligns with your risk appetite and that there is adequate liquidity.
Key takeaways
- Greater liquidity in mutual funds generally indicates lower risk for investors.
- Mutual funds investing in infrequently traded securities tend to have lower liquidity, making quick redemptions more difficult.
- Selling mutual fund units may incur an exit load by the AMC, affecting the overall liquidity of the fund.
- Funds with high liquidity are better suited for short-term financial goals and quick access to cash.
Conclusion
Liquidity in mutual funds is based on the period and costs involved when selling the mutual fund units. Understanding what is liquidity mutual funds is important as it affects the ease with which you can convert your investments into cash and the portfolio's overall risk and return dynamics.
If investing in mutual funds is your objective, you can visit the Bajaj Finserv Mutual Fund Platform to compare mutual funds and invest accordingly. You can also analyse mutual funds schemes using tools such as lump sum calculators and SIP calculators.
