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Liquid Mutual Funds – How they Works?

Liquid mutual funds invest in the debt and money market. These funds invest money in short-term debt securities like treasury-bills, CODs (certificate of deposits), commercial papers, reports, etc. The maturity period of these securities is usually less than 91 days. Here are some short term debt securities:

  • Treasury bill (T-bill) – Treasury bills are funds raised by the Government of India. Since these are funds raised by the state or central, they are called government securities. T-bills are money market instruments, and the maturity of these T- statements varies from 91 to 365 days.
  • Certificate of deposit – This is a term deposit offered by scheduled commercial banks. Unlike fixed deposits, they provide options for negotiation. In simple language, with fixed deposits, the interest rate fluctuates according to market inflation and deflation. But with COD they won’t because the bank and the depositor would negotiate the interest rate and accordingly, the interest will be paid till maturity.
  • Repos – Repos (Repurchase agreements) are short-term loans between a bank and the RBI or between two banks.
  • Commercial papers – These are unsecured promissory notes offered by financial institutions with high credit ratings. In simple language, there are money market instruments which are sold by trustworthy corporations to obtain funds.

Difference between Debt Fund & Liquid Fund

A liquid mutual fund is a part of debt funds. Traditional debt funds invest in short and long-term securities, while liquid mutual funds only invest in short-term securities, ranging from one day to a maximum of 91 days.

Which is Better? Liquid Fund or Saving Bank Account?

Liquid mutual funds are better than savings bank accounts. The reasons are mentioned below:

  • Better interest rates

The interest rate offered by liquid funds is way better than that offered by savings bank accounts. Historically, liquid funds have offered interest at 7 to 8% per annum. On the other hand, a savings bank account interest rate is around 3% return per annum. (Click here to see source)

  • No lock-in period

In mutual funds, there are two types of schemes, which are as follows:

  1. Closed-end schemes
  2. Open-end schemes.

In closed-end schemes, the maturity period is long. So, there will be a lock-in period in these schemes, while liquid mutual funds are open-ended schemes. So, there is no lock-in period. One can withdraw money whenever required. Interest will be paid according to the holding period.

  • Low risk

The risk involved while investing in liquid funds is low but not risk-free. Fund managers choose to invest in high-quality securities with a maturity period of fewer than 91 days. Liquid funds have the added advantage of higher liquidity. Because of the above characteristics, the risk involved is low. Since this fund invests in shorter maturity periods, securities prone to changes in interest rate are also significantly less.

  • Collateral for stock trading

Choose liquid mutual funds as collateral for stock trading. Traders have the option to pledge 90% of the liquid fund for trading. Usually, after 24 hrs of pledging, the amount will be credited to the trading account. A trader can use liquid funds to earn returns from both ways. STT is not charged on liquid funds.

  •  Low exit load

As of October 2020, exit loads of all liquid funds ranged between 0.0070% to 0.0045%, which is very low. We have discussed this in the latter part of the article. Keep reading to know more.

Should You Invest in Liquid Funds?

Choosing liquid funds over banks is the best place to park your money. The reasons are plenty, while some of them have been mentioned above.

Considering the above advantages, you should invest in liquid funds.[5] 

How to Invest in Liquid Mutual Funds?

You can invest in liquid funds in the following two ways:

  • Online
  • Offline

The online method is more convenient when compared to offline. You can sign up for an account with any direct mutual fund that invests in liquid funds. The process is easy; it would take around 24 to 48 hours for account activation.

On the other hand, in the offline method, you have to visit the fund house physically. After filling the form and submitting your request, the account will be created.

  • Taxation

In liquid funds, you can earn through dividends and capital gains. If you earn through a dividend, then no taxes will be charged. But if investors earn through capital gains, then capital gain taxes will be charged.

If you sell funds within three years and have capital gains on funds, you will be charged in the form of taxes for short term capital gains.

If you sell funds after three years, then you will get the benefit of indexation. After adjusting to the indexation, a long term capital of 20% will be charged. Indexation is a measure to account for a reduction in your tax liabilities owing to inflation.

What are the Ways to Find the Best Liquid Fund?

Use the evaluation criteria mentioned below to pick the best liquid fund for investment.

  1. Returns – Liquid funds invest in short-term securities where the maximum maturity period is 91 days. So, the investor should compare the returns of the available funds. After comparing, the investor should pick the one which offers consistently better returns than its peers.
  2. Fund Size – Investors should go with the one with the largest fund size. The reason is that in case of sudden redemption, the fund with larger assets will be less affected than a small-sized one.
  3. Expense Ratio – Initially, we discussed returns as criteria for choosing the best liquid fund. But, if investors were to consider only that one, then he/she won’t be successful in picking the best one. The reason being that since all fund houses invest in short-term securities, there will not be many variations.

In this case, one should go for an expense ratio comparison. The expense ratio is charges levied by the fund house for maintaining it. The returns achieved will be affected badly if the fund house has a high expense ratio. So, go for the one with less expense ratio.

  1. Diversification – The more diversified the portfolio, the lesser the risk in worst-case scenarios. Choose a portfolio that is spread over different issuers. A less diversified portfolio is prone to more deviations.
  2. Exit load – Exit load is charged only if the funds are redeemed within seven days. If redemption is done after seven days, then no exit load will be charged.

Day 1 – 0.0070%

Day 2 – 0.0065%

Day 3 – 0.0060%

Day 4 – 0.0055%

Day 5 – 0.0050%

Day 6 – 0.0045%

Day 7 Onwards – 0%

Liquid Funds best For

  • Investors who have a surplus amount lying in their savings bank account
  • Instead of banks, if the investors choose liquid funds, the returns would be better than savings bank accounts.
  • Investors who want to keep emergency funds
  • An emergency can happen anytime. It is always better to have ready access to your funds. These investors can invest these funds in liquid funds, and whenever required, you can redeem them easily.
  • Investors who want to invest for a short period
  • For shorter span investments, liquids funds are the best option. They provide good returns without capital depreciation on shorter periods.
  • Investors who want collateral for trading
  • A trader can use his/her liquid funds as collateral to raise funds for trading and maximise returns.

Top 10 Liquid Funds(Source – Groww Mutual Funds)

Fund NameCategoryRisk1 Yr ReturnFund Size(in Cr)
Quant Liquid FundDebtLow5.5%192
Franklin liquid India FundDebtLow4.7%1707
IDBI Liquid FundDebtLow4.8%1546
Aditya Birla Sun Life Liquid FundDebtLow4.6%34021
Mahindra Liquid FundDebtLow4.6%2010
Edelweiss Liquid FundDebtLow4.6%1011
Nippon India Liquid FundDebtLow4.6%26077
PGIM India Insta Cash FundDebtLow4.6%659
Tata Liquid FundDebtLow4.7%15958
Axis Liquid FundDebtLow4.6%26509

Conclusion

Liquid funds invest in debt and money markets. Liquid funds are considered to be funds with the least risk. That does not mean zero risks. These are highly liquid. These funds can act as a substitute for savings bank accounts. For good performance, investors should check the past performance of the fund house. Returns vary depending on the market interest rates. These funds are not immune to credit risk. If there is a huge default, there are chances the fund will get affected.    

Liquid Funds are not wealth-creating funds. But a liquid fund is the best option for short term returns. Do not get attracted to returns. Investors should compare all the criteria which were mentioned above before investing. NAV  calculation of liquid funds is based on 365 days, but it is based on business days for other mutual funds. There is no lock-in period. With low exit loads, instant redemption, lower expense ratio, liquid funds can act as the best alternative for saving bank accounts.


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