Liquid funds are debt funds that invest in short-term assets such Treasury bills, government securities, repurchase agreements, certificates of deposit, and commercial paper. Liquid funds are only permitted to invest in debt and money market instruments with maturities of up to 91 days, according to SEBI regulations.

The market price of the securities owned by a liquid fund determines the fund’s return. However, because short-term securities do not fluctuate as much as long-term bonds, liquid funds’ returns are more consistent than those of other debt funds.

How do Liquid Funds Work?

To grasp how liquid funds operate, you must first comprehend where they invest and how they earn returns.

  • Where do Liquid Funds Invest:

A liquid fund will often invest in short-term, high-quality, and highly liquid equities. SEBI recently established a set of rules that have served to enhance these fund characteristics.

These funds can only invest in listed commercial paper, and their overall exposure to a sector is limited to 20%. According to SEBI guidelines, they are not permitted to invest in risky assets. These rules are designed to keep credit risk in the liquid fund portfolio to a minimum.

Liquid funds must also invest at least 20% of their assets in liquid products (cash and cash equivalents such as money market securities). This assures that they will be able to meet any redemption requests immediately.

  • Sources of Earnings:

Liquid funds make the majority of their money from interest payments on their debt holdings, with capital gains accounting for only a small portion of their total revenue. This is a key characteristic of liquid funds, so let’s take a closer look at it.
Bond prices rise when interest rates fall. Bond prices decline as interest rates climb. Long-term bonds have a larger negative relationship between bond prices and interest rates. This means that the longer a bond’s maturity, the more it reacts to market yield swings.
Because a liquid fund mainly invests in short-term securities, its market value is mostly unaffected by changes in interest rates. These funds do not have big capital gains or losses because of this. These funds frequently outperform other debt funds in a rising interest rate environment because their interest earnings are increasing and (ii) capital losses have a limited impact on their market prices. These funds have a very low-interest rate risk, as defined by market jargon.

Advantages of liquid funds

  • Low Risk:

A liquid fund is a low-risk debt investment that focuses on preserving principal and producing consistent returns. As a result, the value of a liquid fund remains relatively constant during market interest rate cycles. Funds owning longer-maturity assets, on the other hand, can experience big capital gains when rates are falling and heavy capital losses when rates are rising.

  • Low cost:

Liquid funds are low-cost debt funds, owing to the fact that they aren’t as actively managed as other debt funds. In actuality, most liquid funds have expense ratios of less than 1%. This low-cost structure enables them to optimize the investor’s effective return.

  • Flexible holding period:

A liquid fund investor can keep his or her money for as long as he or she wants. These funds feature flexible holding periods, despite a slight exit load for redemption within seven days. This makes it simple to enter and exit the investment while still earning secure, market-linked returns over time.

  • Quick Redemption:

Requests for redemption are usually processed within one business day, and some funds even provide rapid redemption. Because liquid funds are invested in highly liquid securities with a low likelihood of default, this is conceivable.

Who Should Invest in Liquid Funds?

  • Investors with a short investment horizon:

Liquid funds are best suited for investors with a three-month investment horizon because they invest in securities with similar maturities. Investors with longer investment horizons, such as 6 months to a year, should invest in funds that have a somewhat longer duration (such as ultra-short duration funds) to generate larger returns.

  • Investors who invest in bank deposits:

Liquid funds offer two advantages to investors who maintain their excess cash in bank deposits: greater withdrawal flexibility and higher yields. In a traditional bank fixed deposit, monies are locked in for a set length of time, and early withdrawal incurs an interest penalty. These funds, on the other hand, allow for longer holding periods and easier exits. Bank savings accounts allow money to be taken at any time, but they only pay roughly 3% to 4% interest, which is less than the 5% plus that a liquid fund typically earns.

  • Investors who want to keep Contingency Funds:

Liquid funds are designed to provide liquidity and safety while earning a modest rate of return. As a result, investors can put money into a liquid fund as an emergency or contingency fund, knowing that it will be protected and redeemed when needed.

  • Investors who need to Park Funds Temporarily:

Liquid funds are cash management products that aim to keep your money secure while also producing a little profit. As a result, a big quantity of money might be temporarily parked in a liquid fund until the investor determines how to invest the corpus, such as from a bonus, property sale, or inheritance.

  • Medium to Route investments in Equity Funds:

Investors can keep their money in a liquid fund and utilize an STP to automatically route investments into an equity fund. This allows them to invest in equity on a regular basis while the liquid fund’s corpus gets consistent profits.

Things to Consider Before Investing in Liquid Funds

Liquid funds are low-risk debt funds that are frequently used as a substitute for bank deposits. Low risk, however, does not imply zero danger! Investors should be aware that liquid funds are not without risk.

First and foremost, returns are not guaranteed, as they are with any mutual fund products. Bank deposits will always pay the promised interest amount when they mature, while a liquid fund’s return is unpredictable because it is based on market interest rates. As a result, investors should look at a fund’s track record and choose funds that have a consistently strong performance.

Second, liquid funds are not credit-risk-free. During the IL&FS downgrading in 2018, it was uncovered that several of these funds had boosted their returns by investing in lower-rated debt securities. When these securities missed interest payments, their credit ratings were lowered, and the liquid funds lost value. Credit risk can be reduced by investing in liquid funds with high-quality portfolios.

Third, liquid funds do not create wealth; rather, they give safety and liquidity in exchange for a small return. Investors must be sure that their financial objectives and expected returns are compatible with the characteristics of liquid funds.

Finally, returns and expenditure ratios must be considered while evaluating liquid funds. Because These funds are primarily generic products, they all produce identical returns at any given time. As a result, a fund with a high expense ratio will have poorer returns in the long run. Consider the following two this funds with yields of 6% and 6.5 percent, respectively. Their running yields (yield minus expenses) are 5.7 percent and 5.6 percent, respectively, if their expense ratios are 0.3 percent and 0.9 percent. Note how a high expense ratio has lowered the investor’s return.

Taxation on Liquid Funds

Liquid funds pay dividends and capital gains to investors. Dividend income from mutual funds is tax-free for investors. If an investor obtains a capital gain by redeeming the fund’s units at a greater price than when they were purchased, the capital gain is taxed.

  • Short term capital gains:

Short-term capital gains are regarded to have been made if an investor sells or redeems the units of a liquid fund after a holding period of up to three years. This is taxed at the investor’s marginal tax rate.

  • Long term Capital Gains Tax:

When a liquid fund is redeemed or sold after more than three years, the capital gain is recognized as a long-term capital gain, and the investor benefits from “indexation.” This means that before calculating the capital gain, the purchase price is adjusted to account for inflation (using a government-provided index). Long-term capital gains are currently subject to a 20% tax rate.

How to Find the Best Liquid Fund

Returns, expense ratio, fund size, and portfolio diversity are all important factors to consider when considering a liquid fund.

  • Returns:

Because liquid funds invest in short-term debt with maturities of up to 91 days, investors should evaluate fund performance over a one-month or three-month period. For a liquid fund, returns over a longer time horizon (one/three years) are meaningless. A high-performing this fund should outperform both its benchmark and peer funds, but investors must ensure that the fund has performed consistently. Examining one/three-month returns over the last five years can confirm this.

  • Expense Ratio:

Because all liquid funds invest in comparable short-term debt instruments, there is little variance in the returns obtained by different fund houses. As a result, it’s vital to evaluate their expense ratios, which are the annual fees a fund charges to manage its investment portfolio. The smaller the final net return to the investor, the higher the expense ratio.

  • Fund Size:

Institutional investors are the primary users of liquid funds. A tiny liquid fund would lose a considerable portion of its assets in the event of a major redemption by an institutional investor, which would have a negative impact on its ability to invest and earn returns. As a result, liquid funds with a bigger asset under management (AUM) are preferred over tiny funds.

  • Portfolio Diversification:

The capacity of liquid funds to maintain the invested corpus safe and steady is why they are so popular. As a result, investors should examine a liquid fund’s portfolio to ensure that it is invested in a variety of securities from various issuers. In the event that any issuer defaults, this will reduce the portfolio’s harm.

Top 5 Liquid Funds Based on Returns

Fund Name3-year Return (%)*5-year Return (%)*
Quant Liquid Plan6.19%6.56%
Franklin India Liquid Fund5.46%6.09%
Tata Liquid Fund5.18%5.88%
Edelweiss Liquid Fund5.24%5.92%
Invesco India Liquid Fund5.28%5.93%

View All Liquid Mutual Funds

The top 5 liquid funds are shown in the table above, ordered by 1-month and 3-month returns. The funds’ returns haven’t differed significantly, as one might expect. However, there is some variation in expense ratios.

If a fund has a higher expense ratio, investors should consider if the fund’s returns are sufficient to offset the higher cost. Investors should also consider fund size: a small fund may outperform larger funds (as seen in this table), but a large liquid fund is more likely to have more consistent returns over time. Also keep in mind that returns for periods less than a year are absolute returns, which must be annualized to be comparable to other returns. A one-month return of 0.77 percent, for example, can be annualised as 0.77 percent x (365/7) = 9.4 percent.

Conclusion

Liquid funds are debt funds that invest in short-term, high-quality, and liquid debt and money market securities with maturities of up to 91 days. As a result, the value of their units tends to be less volatile than other debt funds. Interest earnings provide for the majority of fund returns, with capital gains accounting for only a minor portion of total returns. These funds are a liquid, low-cost, low-risk investment vehicle with a variety of investment possibilities.

These funds are debt funds that invest in short-term, high-quality, and liquid debt and money market securities with maturities of up to 91 days. As a result, the value of their units tends to be less volatile than other debt funds. Interest earnings provide for the majority of fund returns, with capital gains accounting for only a minor portion of total returns. these funds are a liquid, low-cost, low-risk investment vehicle with a variety of investment possibilities.

Also, read: What Are Index Funds And Who Should Invest In Them?

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