Liquid funds are a category of debt funds that require a clear understanding of your investment horizon, as they are categorised based on duration. From overnight funds to long-duration funds of up to 7 years, there are 16 different categories established by SEBI. This initiative helps investors select the right type of fund without feeling overwhelmed by choices. In this guide, we will explore Liquid Mutual Funds and cover everything you need to know before investing.
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 does liquid funds work?
Liquid Funds pool money from multiple investors to generate steady, short-term returns while ensuring high liquidity. Managed by professional fund managers, these funds invest the pooled capital in a diversified mix of short-term debt instruments, which typically feature lower interest rate risk due to their shorter maturity.
The primary objective of Liquid Funds is to preserve capital while providing a reasonable return. Fund managers continuously monitor the portfolio, making investment decisions that align with this goal. The shorter maturity period of the underlying instruments allows investors to access their funds easily when needed, making Liquid Funds a suitable option for those seeking stability and liquidity in their investments.
Features of Liquid Funds
Liquid funds are a type of debt fund that invest in fixed-income assets with short maturities, offering low-risk and high liquidity. Here are the key characteristics of a liquid fund:
- No entry and exit load: Investors can buy and sell liquid mutual funds without incurring extra charges. There is no entry or exit load.
- Variable minimum investment: Liquid funds offer flexibility in investment amounts, suiting various budgets.
- Low-interest rate risk: Due to short maturities, liquid funds carry minimal interest rate risks.
- Quick redemption: Funds can be withdrawn in as little as 24 hours, ensuring high liquidity for investors.
Advantages of liquid mutual 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 should invest in liquid funds?
Liquid funds are an excellent choice for investors seeking stable investment options with good returns. They offer high liquidity and lower risks, making them a preferred option for the following investors:
1. Short-term investors
For individuals or entities looking for short-duration investments with low-risk returns, liquid funds are appealing. These funds generally mature within 91 days, providing a stable and secure option.
2. Cash reserve holders
Investors holding surplus cash can use liquid funds as a way to earn slightly higher returns compared to traditional savings methods. They serve as an effective avenue for storing excess cash with minimal risk.
3. Investors transitioning to equity funds
Those moving from conservative investments to growth-oriented investments like equity funds can benefit from liquid funds. These funds offer stability and low-risk returns while providing flexibility to gradually transition to higher-risk options.
4. Emergency fund builders
Liquid funds are ideal for building emergency reserves due to their high liquidity and competitive returns. They allow quick access to funds in case of unexpected financial needs.
Overall, liquid funds offer a reliable solution for investors seeking low-risk, high-liquidity investments with the potential for competitive returns. Investors should align their choices with financial goals and conduct proper research.
Why should you invest in liquid funds?
Liquid funds offer benefits like:
1. Lower risks
A liquid fund is a low-risk debt investment designed to safeguard principal while offering consistent returns. It remains stable across market interest rate cycles, unlike funds holding longer maturity securities, which may experience high capital gains or losses during rate fluctuations.
2. Flexibility
Liquid fund investors enjoy flexibility, with the option to hold investments for any desired duration. While a small exit load applies to redemptions within seven days, the flexible holding period allows easy entry and exit, ensuring safe, market-linked returns.
3. Fast redemptions
Liquid funds offer rapid redemption, with requests processed within one business day. Some funds even provide instant redemptions, made possible by investing in highly liquid securities with minimal default risk. This ensures quick access to funds 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.
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%.
Taxation rules of liquid mutual funds
- 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.
- 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.
- 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 associated with liquid funds
- 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.
- 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.
- 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.
Factors to consider before investing in liquid mutual funds in India
Before deciding to invest in Liquid Mutual Funds in India, consider the following factors:
1. Investment horizon:
Liquid Funds are ideal for short-term financial goals or as temporary parking funds. For a longer investment horizon, other types of mutual funds may be more appropriate.
2. Risk tolerance:
Liquid Funds are low-risk, but it’s important to assess your risk tolerance to ensure they align with your comfort level.
3. Financial goals:
Define your financial goals clearly. Liquid Funds are suitable for short-term objectives, but for long-term goals, consider other investment options.
4. Liquidity needs:
Liquid Funds offer high liquidity, making them suitable for those who need quick access to funds. However, consider the processing time before making a withdrawal.
5. Safety of investments:
Liquid Funds are generally safe, but it’s essential to review the credit quality of the debt instruments in the fund's portfolio.
6. Potential returns:
Liquid Funds provide stable returns, though typically lower than Equity Funds. Ensure the potential returns meet your financial goals.
7. Expense ratio:
Review the expense ratio of the fund. A lower expense ratio can boost overall returns for investors.
How to invest in liquid funds on the Bajaj Finserv platform?
Step 1: Visit the Bajaj Finserv website or download the app from Google Play Store or App Store
Step 2: Navigate to 'Investments' and click on 'All Investments' on the home page
Step 3: Click on 'Mutual Funds' icon
Step 4: Click on 'Explore Funds'. You will be redirected to the mutual funds listing page
Step 5: Filter by scheme type, risk appetite, returns, etc. or choose from the top performing funds list
Step 6: All the mutual funds of the particular category will be listed, along with the minimum investment amount, annualised return, and rating
Step 7: Click on 'Invest Now'
Step 8: Enter your mobile number and sign in using the OTP
Step 9: 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 10: Enter your bank account details
Step 11: Upload your signature and provide some additional details to continue
Step 12: Choose and select the mutual fund that you want to invest in
Step 13: Choose whether you want to invest as SIP or lumpsum and enter the investment amount. Click on ‘Invest Now’
Step 14: Select your payment mode i.e., net banking, UPI, NEFT/ RTGS
Step 15: 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.
