Liquid funds: Benefits, returns, and risks involved

What is a liquid fund? A type of mutual fund, is the short answer. The long answer? Well, what do you think the rest of this article is for?

What are liquid funds? (The long answer)

Liquid mutual funds focus on debt funds. That means the money from this fund flows into fixed-income instruments such as commercial paper, government securities, and treasury bills. They come with a maturity period of up to 91 days, but the NAV is calculated for 365 days. That said, with liquid mutual funds, it only takes a maximum of 24 hours to withdraw money. They are a great way to ensure liquidity. Hence the name.

These have the lowest interest rate risk, so investors need not worry about bond interest rate fluctuations.

However, investors do need to have a clear view of the investment horizon. Because these funds are classified depending on duration. There are sixteen categories, including overnight funds and long-duration funds, that span 7 years.

How do liquid funds work?

Now that you know what a liquid fund is, it’s time to learn how it works. The focus of these funds is to offer investors liquidity and capital protection. So, as per the scheme mandate, the fund manager chooses top-quality debt securities and investments. While doing this, the manager ensures that the portfolio’s average maturity is not over 91 days.

The risk of changes in interest rates is minimal for shorter maturity.

The manager also matches the maturity of securities with the portfolio maturity to offer better returns. That is returns that are just a little bit better than a savings account.

How to invest in liquid funds

If you wish to make a direct investment, go for one of these two options:

• Asset Management Company (AMC)
• Investment platform

Follow the steps below to go with an AMC or an investment platform directly.

• Your first task is navigating AMC’s website or the investment platform.
• Next, sign in to the account.
• The third thing to do is to fill in the KYC details.
• Finally, compare the liquid funds and select any one.

Otherwise, you will have to look for an intermediary or third party. If you choose this route, you will have to deal with a higher expense ratio because your AMC will have to give the intermediary some commission.

Things to consider before investing in liquid funds

Investing in liquid funds can be simpler if you remember to look at the following things closely.

Risks

The fund’s underlying assets come with a maturity of up to 91 days. But they do not experience too much volatility. The fund’s NAV, therefore, largely remains steady. Remember, the NAV will drop if the credit rating of the underlying security falls. That said, these are not risk-free assets, so some losses can be expected.

Returns

You can get liquid fund returns of around 7–9%. That makes them slightly better than savings account deposits.

Expense ratio

The annual charges that fund management services charge is called an expense ratio. This fee is a percentage-based deduction. Debt investors mostly prefer funds that have a lower expense ratio because it helps increase gains.

Investment plan

Several investors use this investment option to create funds for use in emergencies. While the funds are liquid—just like savings account deposits—they can give better returns despite the low risk. So if you wish to invest money for three months or so, it is a good idea to go with this type of mutual fund instead.

Financial goals

People can yield profits with a maturity period of 91 days, which is a pretty short time. So these investments can help you fulfill any short-term financial goals with ease.

Tax on gains

Debt taxation applies to this investment option. If the fund is sold before three years, short-term capital gains tax applies. If you redeem your money after three years, the long-term tax applies. And the indexation helps.

Benefits of liquid funds

Liquid mutual funds come with a variety of benefits. We discuss some of them below.

Low risk

You should know that debt funds don’t have any connection with the market. Plus, usually, if you hold debt funds for long periods, they become riskier. But that is not the case with liquid funds. Hence, the ninety-one-day period makes it a safe option for investors. It has improved securities and lesser risks. Therefore, for all of these reasons, this is a low-risk option.

However, these funds do come with interest risks.

Low cost

These funds come with a small expense ratio. The reason is that despite not being managed actively, they invest in A-rated securities.

Protection against inflation

Liquid mutual fund schemes can invest in fixed-income instruments, such as debentures and bonds. While these mutual funds come with a short maturity tenure, they are very volatile. Besides, they offer a fixed interest rate that is close to the inflation rate. Therefore, they act as an effective barrier against inflation.

Quick redemption

You can withdraw your money within one day.

Conclusion

Liquid debt funds offer a stable income, and there are fewer risks. And all the while, liquidity is just 24 hours away. So this is a great option if you are looking for a low-risk investment that is something like a savings account.

FAQs