Looking For Short-Term Investments? Focus On Liquid Funds!

What would be the first thing most of us do if we have surplus money at our disposal? If we do not spend it or have not yet decided how to use it, we would keep it in our savings bank account. Did you know that there is a possibility of this money earning more than savings bank interest rate and yet have anytime liquidity? 

Enter Liquid funds!

What are Liquid Funds? 

Liquid funds are debt mutual funds, which invest, in very short-term fixed income instruments (example bonds) issued by government, banks, public and private companies. According to Sebi regulations, these instruments have a maturity of up to 91 days. Liquid funds are among the least risky categories of debt mutual funds given the very short-term nature of underlying instruments. Furthermore, the expense ratio charged by these funds is very low (average of 0.15% for direct schemes).

Instant Access To Cash

For enhancing the ease of use of liquid funds, certain AMCs offer insta-redemption facility on their liquid funds. Through this facility, investors can withdraw up to Rs 50,000 or 90 per cent of their investments (whichever is lower) in liquid funds and get the same in their bank account instantly.

Steady Performer At All Times

Unlike Savings bank account interest or a bank FD, debt mutual funds are market-linked products that do not offer assured returns. Debt mutual funds including liquid funds do have some interest rate risk and credit or default risk. Yet, liquid funds have been offering consistent returns historically. To understand how, let us compare the yearly returns of liquid funds with gilt funds, since both these categories are low on credit risk. Gilt funds invest in Govt. of India bonds, which have negligible risk of default. Liquid funds on the other hand predominately invest in top quality (high credit rating) instruments, which are very short term in nature, thus mitigating credit risk to a large extent.

Note: Average returns of top 5 funds by AUM are taken into consideration across both categories. Government Bond Funds represent Gilt Funds. All return figures are in absolute percentage terms.

However, the above table highlights the wide variation in yearly returns of gilt funds. This is because interest rate risk is higher in gilt funds, since they invest in long term government bonds. Liquid funds on the other hand carry lesser interest rate risk as they are stipulated to invest in very short-term instruments only.

Scenarios Where You Can Use Liquid Funds:

· People who have idle cash in their bank accounts for short span of time or where utilization is not yet decided, for example, from a property sale or year-end bonus

· Life is unpredictable and there can be adverse situations, which may require sudden cash outflows. To help you tide over such situations, you may use liquid funds to create & maintain an emergency fund

· People who want to invest a lump sum amount into equity mutual funds, should rather invest the entire sum in liquid fund and start a STP (systematic transfer plan) to the equity fund of your choice, to take advantage of cost averaging over time

· Salaried persons can park their salary in insta redemption funds and withdraw it as and when needed

· Businesses can park their daily surplus in liquid funds and earn returns on the same rather than keeping it in current account and getting no interest

Selecting the Right Liquid Fund

There are almost 40 liquid funds offered by different mutual fund houses. So, making the right choice can be a daunting task! The following points can serve as guide in choosing the right liquid fund:

1. Ensure that the fund has a large AUM: Having high AUM will make sure that there is less concentration in the portfolio. Also, this will reduce the redemption pressure and limit the loss in NAV in times of crisis.

2. Don’t choose a fund based on past returns only: Given the instruments that these funds invest into, it is hard to generate higher returns than the category without investing in riskier instruments. Funds investing in such risky instruments have high chances of facing drop in NAV due to defaults. So, don’t get lured by funds offering highest returns.

3. Choose a fund with high credit quality: This is arguably the most difficult parameter for a retail investor to assess. The greater the credit quality of the portfolio, the lesser is the credit risk of the fund. All else being same, a liquid fund that gives significantly higher returns compared to peers is probably having a lower credit quality.

4. Finally, choose a fund with lower expense ratio

Other Benefits Of Liquid Funds

Apart from earning high returns in liquid funds compared to saving bank account, liquid funds also have taxation benefits in case you park money for longer term. Savings bank account interest (over Rs10,000 per annum) are taxed based on an individual’s tax slab, however if you hold liquid funds for more than 3 years, capital gains are taxed at 20 per cent with the benefit of indexation.

 Some Regulatory Changes Coming

In response to the ongoing issues in the debt markets, Sebi has proposed some changes in regulations governing debt mutual funds:

1. Sebi has proposed to levy a graded exit load on investors of liquid funds who redeem from the fund within 7 days of investing. Currently liquid funds do not have exit load.

2. Sebi’s proposals with respect to change in valuation of fixed income instruments can make liquid funds a tad more volatile than earlier.

However, we believe that whenever these are implemented, the thesis for choosing liquid funds by retail investors should not change. 

In conclusion, liquid funds remain one of the best-placed debt mutual fund categories (for short term and emergency needs) that offer a higher degree of capital protection and relatively steady returns.

The author is Whole Time Director at Paytm Money