Liquid funds, a category of mutual funds, predominantly invest in short-term money market instruments with maturity periods up to 91 days. These funds consider low-risk and invest in highly liquid instruments like treasury bills, certificates of deposit, and commercial papers. With lower volatility than other mutual funds, they prioritise liquidity and capital preservation over short durations, ideal for investors with surplus funds.
Liquid funds offer higher returns than traditional deposits and allow investors to sell units without exit loads after 6 days. Regulated by SEBI, these funds maintain exposure limits to issuers and adhere to stringent investment guidelines for high-quality securities. In this article, you will know in detail what liquid funds are and how do they work, advantage of liquid funds and more.
What are Liquid Mutual 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.
Let us understand how liquid funds work:
Where do they invest
- Liquid funds primarily invest in short-term, high-quality, and highly liquid securities, following recent SEBI guidelines.
- They typically invest in listed commercial papers, with a sector exposure limit of 25%.
- Liquid funds avoid risky assets per SEBI norms to mitigate credit risk.
- These funds must allocate at least 20% of their assets to liquid products, ensuring liquidity for redemption demands.
Earning source
- Liquid funds mainly earn through interest payments on debt holdings, with minimal income from capital gains.
- Due to their short-term nature, liquid funds are less affected by changes in interest rates compared to long-term bonds.
- In a rising interest rate scenario, liquid funds tend to outperform other debt funds as their interest earnings increase, and market values experience limited impact from capital losses.
- Liquid funds are characterised by very low-interest rate risk, making them resilient in various market conditions.
Advantages of Liquid Funds
Liquid funds offer investors high liquidity, low risk, and potential for competitive returns. These funds invest in short-term, high-quality securities, ensuring quick redemption and minimising the risk of capital loss while offering attractive yields. Let us explore the various 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.
Who can invest in Liquid Funds?
Liquid funds are suitable for a wide range of investors, including individuals, corporations, trusts, and institutions seeking high liquidity, low-risk investment options with potential for competitive returns. 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.
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
Before investing in Liquid Mutual Funds in India, consider factors such as the fund's expense ratio, credit quality of underlying securities, past performance, liquidity, and the fund manager's expertise and track record. Let us explore these factors in details:
- 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.
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.
What are the returns on Liquid Funds?
Liquid mutual funds, like Liquid BeES, may offer moderate returns compared to equity or debt funds. Their returns are primarily influenced by prevailing interest rates since they invest in short-term debt securities. Liquid BeES, being an ETF in India, tracks the performance of highly liquid debt instruments.
Liquid fund returns tend to be stable and less volatile, making them suitable for investors with a low-risk tolerance. The average returns of liquid BeES over recent years have ranged from 3% to 5%.
