What are Liquid Funds: Meaning, Benefits and How to Invest

Understand liquid funds, how they operate, and the cost associated with them.
What are Liquid Funds?
3 mins
14 Feb 2024

Liquid funds are a type of mutual fund that primarily invests in short-term money market instruments with a maturity period of up to 91 days. These funds are considered low-risk investments as they invest in highly liquid instruments, like treasury bills, certificates of deposit, commercial papers, and other short-term instruments.

These instruments are less volatile as compared to other mutual funds. These funds aim to provide ease of liquidity and capital preservation in a short duration, making it ideal for investors with surplus funds who need to park their money for a short-term period.

Liquid funds give higher returns than traditional deposits. Liquid funds also offer the advantage of exit load application only up to 6 days, which means that investors can sell their investment units at any time after 6 days of investment, unlike other mutual funds that attract an exit load if the units are sold before the initial investment period.

These funds are regulated by the Securities and Exchange Board of India (SEBI) to ensure that they invest in highly liquid and high-quality securities.

Additionally, these funds are required to maintain a limit on the exposure to each issuing entity and adhere to a strict set of investment guidelines.

What are Liquid Funds?

Liquid funds are a type of Debt Mutual Funds that mainly invest in short-term debt securities, offering fixed returns. These securities typically include money market instruments like treasury bills, commercial paper, and certificates of deposits with maturities of up to 91 days. The primary benefit of investing in liquid funds is their high liquidity, which means how fast an asset can be bought or sold and converted into cash. Liquid funds provide investors with easy access to their money when needed, making them a convenient option for short-term investments with stable returns.

How do Liquid Mutual Funds work?

Liquid Mutual Funds are debt mutual funds that primarily invest in short-term money market instruments with maturities of up to 91 days. They aim to provide investors with a safe and liquid investment option. When you invest in a Liquid Mutual Fund, your money is pooled with that of other investors, and a fund manager manages the corpus. These investments offer relatively stable returns and high liquidity, making them suitable for parking surplus funds, emergency funds, or short-term financial goals. Investors can redeem their units at any time

Advantages of Liquid Funds

  • Less Risk: Liquid funds, categorised as low-risk debt funds, prioritise safeguarding principal amounts and providing consistent returns. Consequently, these funds maintain a relatively stable value throughout varying market interest rate cycles. In contrast, funds invested in longer-maturity securities may experience substantial capital gains during declining rates but equally heavy losses during rising rates.
  • Cost-Effective: Liquid funds boast a cost-effective structure, operating with expense ratios typically below 1%. This affordability, stemming from less active management compared to other debt funds, ensures that investors receive a maximised effective return on their investment.
  • Flexible Holding Period: Investors in liquid funds enjoy flexibility in holding periods, allowing them to retain investments for as long as necessary. Although a slight exit load applies to redemptions within seven days, the overall structure accommodates easy entry and exit, enabling investors to earn secure, market-linked returns throughout the investment period.
  • Swift Redemption: Liquid funds prioritise investor convenience by processing redemption requests within one working day, with some offering instant redemption facilities. This efficiency is achievable due to investments in highly liquid securities characterised by low default probabilities.

Should you invest in Liquid Mutual Funds?

Whether you should invest in Liquid Mutual Funds depends on your financial goals and risk tolerance. If you have surplus funds that you don't need immediately and want to earn slightly higher returns than a regular savings account or fixed deposit, Liquid Mutual Funds can be a suitable choice. They offer better returns than traditional savings accounts, and their high liquidity allows you to access your money quickly when needed.

When should you invest in Liquid Funds?

Investing in Liquid Funds is advisable for individuals seeking short-term solutions for their idle cash, as recommended by financial experts. Offering superior returns compared to savings accounts, liquid funds provide an efficient avenue for parking surplus funds. The accrued corpus can subsequently be utilised to meet short-term financial goals within the next 4-5 months. For those aiming for a more strategic approach, employing a Systematic Transfer Plan (STP) enables the gradual transfer of capital from a liquid fund to a Systematic Investment Plan (SIP) installment in an equity fund. This not only amplifies returns but also serves as a valuable strategy to mitigate market volatility over an extended period, aligning investments with long-term financial objectives.

Factors to consider before investing in Liquid Mutual Funds in India

  • Investment Horizon: Liquid funds are designed for short-term investments. Ensure that your investment horizon aligns with this objective.
  • Risk Tolerance: Liquid funds are low-risk, but they are not entirely risk-free. Understand the minimal credit risk associated with the underlying securities.
  • Expense Ratio: Check the expense ratio of the fund, as lower expenses can lead to higher returns for investors.
  • Investment goals: Many investors use liquid funds to build emergency funds, offering good returns with low risks and high liquidity. Designed for a 91 day horizon, align your investment plan accordingly.

Who can invest in Liquid Funds?

Investing in liquid funds can be good for:

  • Those seeking short-duration investments with lower risks.
  • Individuals holding a significant amount of uninvested cash.
  • Investors using liquid funds as a gateway to equity funds.

How to find the best liquid funds to invest in?

The primary analytical criteria for evaluating a liquid fund include its returns, expense ratio, fund size, and level of portfolio diversification.

  • When evaluating returns, it is essential to consider the performance over short-term investment horizons such as one or three months since liquid funds primarily invest in short-term debt securities with a maturity of up to 91 days. Liquid funds with superior returns, which consistently outperform their benchmark and peer funds, are better suited for investment.
  • In comparison to other fund types, returns earned by liquid funds rarely vary, thus comparing their expense ratios is critical. The expense ratio is the annual management fee charged by a fund and lowers the net returns for investors. Thus, to maximise value, investors should choose liquid funds with lower expense ratios.
  • Considering the risk of sudden large redemptions by institutional investors, liquid funds with larger assets under management (AUM) are better suited for investment. This safeguards the fund against sudden outflows that could significantly impact its ability to invest and generate returns.
  • Investors should also assess the level of portfolio diversification, which is particularly important for minimising portfolio damage in case of an issuer's default. Checking that a fund's portfolio includes investment in several securities across different issuers ensures a safe investment with stable returns.

Taxes on liquid funds for resident individuals

  1. Short-Term Capital Gains Tax (STCG) is applicable if an investor sells the units of a liquid fund within three years of purchase, these are taxed based on the investor’s income tax slab.
  2. Long-Term Capital Gains Tax (LTCG) is applicable if an investor sells the units of a liquid fund after three years of purchase, with a tax rate of 20% with indexation benefit.
  3. Tax on Income distribution (IDCW Option) is applicable on dividends distributed by liquid funds to investors, and it is also taxed according to the investor’s income tax slab. Tax will be deducted at 10% if the income distributed by way of dividend exceeds Rs.5000 during a financial year.

Risks of Liquid Funds

  1. Credit Risk: Liquid funds are not entirely immune to credit risk. Although they predominantly invest in short-term debt instruments with high credit ratings, there's still a slim possibility of default by the issuer. In such cases, the fund's NAV (Net Asset Value) may be adversely affected, impacting investor returns.
  2. Interest Rate Risk: Liquid funds invest in debt securities, making them susceptible to interest rate fluctuations. If there is a significant shift in interest rates, the value of these securities may experience changes. When interest rates rise, the existing securities with lower rates become less attractive, potentially leading to a decline in the fund's NAV and, consequently, returns for investors.
  3. Inflation Risk: Despite being relatively low-risk, liquid funds are not entirely immune to inflation risk. Inflation erodes the purchasing power of money over time. If the returns generated by a liquid fund fail to outpace the inflation rate, investors may find that their real returns (adjusted for inflation) are lower than expected, impacting the growth of their capital. Investors should be mindful of inflationary pressures when considering liquid funds as an investment option.

How to invest in mutual funds?

  • Step 1: Click on INVEST NOW. You will be redirected to the mutual funds listing page.
  • Step 2: Filter by scheme type, risk appetite, returns, etc. or choose from the top performing funds list.
  • Step 3: All the mutual funds of the particular category will be listed, along with the minimum investment amount, annualised return, and rating.
  • Step 4: Get started by entering your mobile number and sign in using the OTP.
  • Step 5: Verify your details using your PAN, date of birth. If your KYC is not complete, then you will have to upload your address proof and record a video.
  • Step 6: Enter your bank account details.
  • Step 7: Upload your signature and provide some additional details to continue.
  • Step 8: Choose and select the mutual fund that you want to invest in.
  • Step 9: Choose whether you want to invest as SIP or lumpsum and enter the investment amount. Click on ‘Invest Now’
  • Step 10: Select your payment mode i.e., net banking, UPI, NEFT/ RTGS.
  • Step 11: Once your payment is done, the investment will be complete.

Your investment will start reflecting in your portfolio within 2-3 working days.

Conclusion

In conclusion, liquid funds are an excellent investment option for investors who are looking for a comparatively low-risk, stable returns with quick and easy access to their funds. These funds also aim to provide returns higher than savings accounts. However, as with any investment option, investors must conduct thorough research and analysis before investing their money in any mutual fund including liquid mutual funds.

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Frequently Asked Questions

Is Liquid Fund better than FD?

Liquid Funds offer returns comparable to short-term FDs, making them a viable alternative. Their key advantages include no mandatory lock-in period and no withdrawal penalty after 7 days.

Can we do SIP in liquid funds?

Yes, you can do SIPs in liquid funds to regularly invest and potentially earn good returns than keeping money idle.

Do liquid funds have a lock‐in period?

Liquid funds typically do not have a lock-in period; you can redeem your investment anytime.

Do liquid funds have an exit load?

You only need to pay an exit load if you redeem within seven days of investing your money. There is no exit load after that.

Is Liquid Fund Safe?

Liquid Funds are considered among the safest mutual funds, lending to reputable companies for brief periods, minimizing risk. Staying invested for a while ensures near-zero risk of capital loss.

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