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Everything You Need To Know About Liquid Funds

When it comes to investing in funds that offer better returns than bank account while enjoying minimal risks, liquid funds can be your allies. Being immune to interest rate changes and letting you enjoy the ease to withdraw cash as and when it is required, liquid funds also make your money easily accessible while also maintaining the growth.
Everything You Need To Know About Liquid Funds

Rajesh has received a Diwali bonus from his office. He wishes to buy the latest iPhone XI for his wife. The money that he has saved up for the mobile phone has been lying idle until the launch of the latest model.

On the other hand, Rajesh’s colleague Dinesh has also received a bonus of a similar amount and is waiting to buy a new laptop for his son, who is about to join an Engineering college. While he awaits the completion of the admission formalities, he invests the money in liquid funds. By the time his son joins the college and decides on the model to buy, Dinesh uses the returns not only to buy the laptop but also buy a hard disk!

Do you notice the difference between the two scenarios? How did Dinesh manage to maximize his wealth and gain more from the principal, which was the same for both, Dinesh and Rajesh? 

Of course, the major difference lies in the investment made by Dinesh. So this brings us to the question: what is liquid fund and how does it work? Let’s have a look at everything that you need to know about the best liquid funds! 

What are Liquid Funds?

Liquid mutual funds invest your money in treasury bills, Government security, Collateral Borrowing and Lending Obligation (CBLO), bank fixed deposits, call money, commercial papers, treasury bills, and other such short-term (with maturity up to 91 days only) financial instruments. After witnessing a slow lull in the past few years, the Indian market is witnessing the comeback of liquid funds.

What’s What of Liquid Funds

Collateral Borrowing and Lending Obligation (CBLO)
CBLO is operated by the Clearing Corporation of India Ltd. (CCIL). It represents an obligation between a borrower and a lender. It is similar to a bond wherein the lender buys CBLO and the borrower sells it with interest.
Bank Fixed Deposits
Bank fixed deposits (or FDs, aka term deposits) are offered by banks and non-bank financial institutions (NBFCs), wherein the investor gains a higher interest on a lumpsum amount than the gains made through regular savings account interest. However, the sum gets fixed for a fixed tenure.
Call Money
Call money is money loaned out by a bank, which needs to be repaid on demand. Unlike a term loan, call money does not have a maturity or repayment schedule. The lender does not have to publish any notice for repayment either. It is one of the most liquid assets for banks, second to cash.
Commercial Papers
It is a form of unsecured debt, that is, a loan without any collateral. It is normally issued by large financial institutions. 
Treasury Bills (T-bills)
Treasury bills are short-term loans that are backed by the Government.

These mutual funds are not bound by any prescribed lock-in period. Additionally, redemption requests are acceded to immediately and the money is credited to your bank account within 24 hours on a business day.

For example, if you make a redemption request within the cut-off time, say, at 2 PM, the money will be released within the cut-off time. (Do note that the units allotted would be as per the NAV of the previous day). It may also be mentioned here that liquid funds do not bear any entry or exit load (unless you are redeeming the liquid fund within seven days). Hence, due to the high degree of liquidity offered by these mutual funds, they are termed as ‘Liquid Funds.’

Unlike other debt mutual funds, the Net Asset Value (NAV) of Liquid Funds is calculated for a period of 1 year, that is, 365 days. On the other hand, debt mutual funds calculate NAV only for business days. Another major difference between liquid funds and debt mutual funds is that liquid funds have lower interest risk. This low-risk characteristic is a result of investment in fixed income securities with a short maturity.

How do Liquid Mutual Funds work?

Now that you know what liquid funds mean, let us have a look at how they work.

To ensure high liquidity without compromising on the safety, fund managers invest the capital in high-credit quality debt instruments. High-credit quality debt instruments are not only less volatile but they more likely to regularly pay the interest on the debt security and principal amount upon their maturity. The fund manager proportionately allocates the principal depending on the fund’s investment mandate while also ensuring that the average portfolio maturity is three months.

Due to such practice followed by the fund manager, the funds are less sensitive to the change in the rate of interest. Further, the maturity of the underlying securities is in line with the entire portfolio maturity, which also results in higher returns.

Various Money Market Instruments

The best performing liquid funds strike the perfect combination of investment allocation in various money market instruments. However, as an investor, you must know the different money market instruments involved in liquid mutual funds:

Certificate of Deposit (CD)

Just like fixed deposits offered by scheduled commercial banks, a CD is a time deposit. However, the primary difference between the two is that you cannot withdraw from a CD before the expiry of the fixed tenure.

Commercial Paper (CP)

Companies and financial institutions issue commercial papers, also known as promissory notes, that bear a high credit rating. These unsecured money instruments are issued at a discounted rate but at redeemed at face value. The investor makes a profit from the difference between the two.

Treasury Bills (T-Bills)

The Government of India issues Treasury Bills to raise money on a short-term basis for up to 365 days. Since T-bills are backed by the Government, they enjoy the reputation of being the safest investment avenue. However, the rate of return is low for T-bills when compared to other money instruments.

Advantages of Liquid Funds

Short-term investment of your money in liquid funds could grant you with the following advantages:

Greater Degree of Liquidity

The greatest advantage of Liquid Mutual funds is the ability of investors to enter and exit the funds as and when required. Further, there is no amount specified for making the investment. Most importantly, the investment can be redeemed in a matter of 24 hours so you can have your money at hand whenever you want. All of this is possible due to the investment of the funds in highly liquid short-term debt and money market instruments.

Minimal Volatility

When you invest in liquid mutual funds, you can expect very little fluctuation or volatility. When compared to any other debt mutual fund investment, liquid funds bear the lowest level of interest rate risk. The reduced risk is due to the fact that liquid funds invest in short maturity (91 days) money market instruments and fixed income securities.

Higher Returns

When compared to a savings account, which offers interest at the rate of 3-4%, liquid funds offer an annualized returns that hover around 6-7%.

Fast and Easy Redemption

Through the Instant Access Facility (IAF), liquid funds investors can instantly redeem their investment. As per IAF guidelines, on the receipt of your redemption request, you will instantly get credit up to the value of Rs. 50,000 or 90% of the latest value of your investment, whichever of these is lower.

High Credit Quality

As they carry the lowest credit risk, liquid funds are considered to be a highly safe investment. The high credit quality may be credited to the fact that the funds are invested in government-backed securities and AAA-rated money market instruments.

Limitations of Liquid Funds

Following are the limitations of investing in liquid funds:

Market Risks

While liquid funds do enjoy having an extremely low risk, they are not entirely risk-free. As the funds are invested in debt instruments, your investment is still vulnerable to interest rate risk and credit risk.

Fluctuating Interest Rate

Unlike savings bank accounts that give a stable and standard interest rate throughout, liquid funds have fluctuating interest rates that may impact the price of the debt instruments. As a result, even the NAV of the liquid fund may fluctuate. Given the short-term nature of this investment, these fluctuations may develop into something negative.

Tax Liability

Unlike money accrued in a savings bank, which is non-taxable (for interest up to Rs. 10,000/-), tax on liquid funds follows a complex structure. If you hold liquid funds for more than 3 years, then you are eligible for Long-Term Capital Gains Tax (LTCG) along with the indexation. On the other hand, if you sell your liquid funds before 3 years then the liquid funds' taxation shall be as per the tax slab that you fit.

If you have selected to invest in dividend-based liquid funds, you will have to a dividend distribution tax of 29.12%

All About Investments in Top Liquid Funds

Let’s have a look at what you need to know before you invest your money in the best liquid funds:

Who Should be Investing in Liquid Funds?

Parking your money in Liquid Funds shall give the best result for individuals meeting the following criteria:

Those Looking for Short Term Investment

Investors who have a lot of surplus money that is lying idle or is awaiting deployment can be invested temporarily in liquid mutual funds. This strategy will not only keep your investment safe but will also yield attractive risk-free returns even over a short duration.

Those Wishing to Save Money

One can easily withdraw the money stored in a savings bank account. If you wish to instil a saving practice, you can put your money in liquid funds. As such, you not only control the cash flow but you also restrict frivolous expenses while also gaining interest on the money saved.

Those Looking to Set Up an Emergency Fund

Due to the highly liquid nature of the investment, investors park their money in liquid funds for setting up an emergency fund. Normally, the adequate amount for the emergency fund would be about 4 months of your salary. Through an emergency fund, you will be prepared for any financial stress or crisis, be it the loss of job or medical condition.

Factors to Consider as an Investor

As a smart investor, you would naturally wish to invest in the best liquid mutual funds. To ensure that you get nothing but the best, here are a few factors that you must bear in mind:

Risk

Many factors influence the risk associated with the investment. Mostly, the NAV does not undergo drastic changes in the case of liquid funds. The underlying assets mature within 60 to 91 days, which allows the fund's NAV to be least affected by the fluctuations. 

However, the fund value is likely to drop in cases where the credit rating of the company drops. As such, the investment is not risk-free.

Returns

Historically, liquid funds have had the capacity to deliver returns in the range of 7% to 9%. While there is no guarantee on a fixed rate of interest, the final amount on redemption will definitely follow a positive trend.

Cost

‘Expense ratio’ is the amount paid for the management of your investments in liquid funds. As per SEBI guidelines, the expense ratio cannot be more than 1.05%. Fund managers maintain a lower expense ratio as the funds are meant to be held until maturity.

Investment Horizon

The primary purpose of liquid funds is to hold surplus cash for a short period. Investment horizon refers to the duration for which you wish to invest your money. Having an investment horizon that is this short helps in realizing the full potential of the parked amount. However, if your investment horizon is broader, say, one year or so, then you may opt for ultra short-term funds in place of liquid funds.

Financial Goals

It is important to consider the purpose of starting the investment in a liquid fund. Are you looking to create an emergency fund from which you can withdraw money as and when required? Then liquid funds would be the best choice for you. Thus, while your money stays put, readily available depending on your needs, it also attracts a respectable amount of interest.

Similarly, list out your financial goal and check which kind of investment best suits this purpose.

Liquid Fund Returns that Investors can Expect

On receiving the redemption request, the investment and money are credited to your bank account the very next day. There are no exit or entry loads for investing in liquid mutual funds. Most importantly, according to the data collected by Value Research, liquid funds have given a return of between 6%-7% over the past year.

Risks Associated with Investing in Liquid Mutual Funds

Investing in liquid mutual funds bear the same risks as a debt mutual fund. However, due to the fact that the investment is directed towards low-risk funds with the least amount of volatility, the risk is somewhat minimized.

Golden Rules to Evaluate the Best Liquid Funds

Here are a few pointers that will help you choose the best liquid funds in 2019:

Fund Performance

The performance of your liquid funds plays a vital role in helping you determine whether the fund is worth your money. Look for the best performing liquid funds that have stayed consistent in outperforming their peers. However, it is also important to factor in your investment horizon. Depending on your investment horizon, certain liquid funds may perform better than others.

Historic Fund Patterns

In addition to the performance, you must also monitor the track record of the liquid fund that interests you. Fund houses that have a history of performing well will continue to do so even during the market slump or rally. Thus, find a fund that is reliable and is backed by a solid history.

You can also test the credibility of a liquid fund by checking its credit rating. The highest credit rating that could be given to a fund house is AAA. A liquid fund that has a high credit rating will be less likely to default, and as a result, will be a less risky affair.

Expense Ratio

As mentioned earlier, ‘expense ratio’ is a part of your investment that is required for the efficient operation and handling of your mutual funds. Your fund managers will deduct this amount as fees for handling your business for you. Naturally, a lower expense ratio means that you get to take home a larger chunk of the investment. Hence, choose a liquid fund that strikes a balance between low expense ratio and high performance.

How to Invest in Liquid Funds?

To invest your money in Liquid Funds, head over to the official Scripbox website and follow the steps outlined below:

  1. Scroll to the lower half of the welcome page to locate the “Get Started, begin your investment journey” 
  2. Amongst the five options available, click on ‘Achieve Life Goals’ 
  3. Next, select the ‘Emergency Money’ option to start investing in liquid mutual funds.
  4. You will now be directed to a page wherein you need to fill your details such as your age and present monthly salary, etc.
  5. Scripbox will calculate the sufficient amount that is a must as your emergency fund. The site auto-populates a list containing the period along with the corresponding pay.
  6. Depending on the cash flow and the duration, select a plan that suits you best.
  7. Review and confirm the plan.
  8. If you do not have an active account on Scripbox, now is a good time to log-in or create a new account
  9. Complete the KYC formalities by sharing your bank account details and PAN card with the website.
  10. You are now ready to start investing in liquid funds through Scripbox!

Best Liquid Funds of 2019

Let us now take a look at the best Liquid Funds of 2018-19 as suggested by Scripbox.

Axis Liquid Fund (Growth)

Axis Liquid Fund (Growth) was launched on the 01st of January 2013. It is known for giving impressive returns and features highly in the list of best liquid funds.

Here is a brief snippet containing all the information on Axis Liquid Fund (Growth):

S.No.Basic/Investment Detail Parameter
Value
1Category
Debt: Liquid
2Fund House
Axis Mutual Fund
3Risk Grade
Low
4Return Grade
Average
5Type
Open-Ended
6Return Since Launch
8.04%
7Minimum Investment (in Rupees)
500
8Minimum Balance (in Rupees)
1
9Expense Ratio (as on 31st July 2019)
0.11%
10Crisil Rank
3 Stars

Fund Performance of Axis Liquid Fund (Growth):

Period
Returns (per year)
6 months
3.51%
1 year
7.31%
3 years
7.08%
5 years
7.57%
10 years
--

Tata Liquid Fund (Growth)

Erstwhile known as Tata Money Market Fund, Tata Liquid Fund was launched on the 1st of September 2004.

Here is a brief snippet containing all the information on Tata Liquid Fund (Growth):

S.No.Basic/Investment Detail Parameter
Value
1Category
Debt: Liquid
2Fund House
Tata Mutual Fund
3Risk Grade
Low
4Return Grade
Above Average
5Type
Open-Ended
6Return Since Launch
7.63%
7Minimum Investment (in Rupees)
5,000
8Minimum Balance (in Rupees)
-
9Expense Ratio (as on 31st July 2019)
0.27%
10Crisil Rank
3 Stars

Fund Performance of Tata Liquid Fund (Growth):

Period
Returns (per year)
6 months
3.47%
1 year
7.27%
3 years
7.04%
5 years
7.55%
10 years
7.84%

SEBI’s Latest Guidelines of 2019 to Make Liquid Funds Safer

  • The stress in the market has necessitated the need for SEBI’s intervention to regularize the liquid funds' portfolio. Here are a few highlights of the latest guidelines that aim to boost liquid funds:
  • Valuation of the securities will take place entirely through a marked-to-market basis. Thus, the securities available with the liquid fund portfolio will be valued at the prevailing market rate.
  • In place of 60 days, bonds maturing after 30 days will be valued at market price. 
  • The practice of the amortization of funds has been done away with.
  • Increased transparency and liquidity through marked-to-market transactions.
  • Liquid funds will now have to hold at least 20% in liquid assets in the form of cash or cash equivalents (like treasury bills and repo on government securities)
  • The imposition of a graded exit load for investors who exit the fund within seven days.
  • Liquid and overnight funds will no longer be allowed to invest in short-term deposits, money market instruments, debts, and instruments having credit enhancements or structured obligations.
  • Exposure to a single sector has been reduced from 25% to 20%.

Final Thoughts

Whether you wish to park your idle money or wish to create an emergency fund, liquid mutual funds are a promising investment option to meet your financial goals. These short-term investments are absolutely liquid and are perfect to earn good returns. 

The most important feature of liquid funds revolves around better than bank account returns while enjoying minimal risks. Liquid funds are immune to interest rate changes and allow you to withdraw cash as and when it is required. Thus, your money is easily accessible while also growing.

Normally, it is advisable to avoid investing your money in liquid funds for 10 or so days as it will result in loss of capital and because of new exit loads being brought in. Ideally, a three to six-month tenure is suitable for liquid funds. However, it must also be mentioned that you need to factor in your personal requirements, capital, and investment horizon before reaching a decision on such investments. Hence, you must carry out your homework and personally decide the liquid funds that you wish to invest in.

A number of corporates and individuals are making use of liquid funds to make good use of their idle money. Unfortunately, it does not have the level of popularity that fixed deposits and savings bank accounts enjoy. However, it is simply a matter of time when smart investors identify the benefits of liquid mutual funds and exploit it to the fullest.

Which is your preferred mode of savings? Let us know in the comments below!

Frequently Asked Questions (FAQs)

Here are a few frequently asked questions with respect to liquid funds.

Do Liquid Funds offer any tax relief?

o. Liquid funds do not offer any tax relief or tax benefit.

In fact, in case of liquid funds that have been held for three years, the capital gains from the liquid funds shall be added to the investor’s income and they will be taxed as per his tax slab. In cases where liquid funds are held for more than three years, the investor has to pay long term capital gains tax at 20% with indexation. However, in some cases, when you factor in inflation, the effective tax becomes nil.

What is the main difference between Liquid Funds and Debt Funds?

Liquid funds are more focused on short-term investments where you park your idle money. It could also be a medium for setting up an emergency fund. Due to the short tenure of the investment, the volatility associated with the liquid funds is low.

On the other hand, debt funds are similar to gilt or income funds that are invested in a wide range of debt and money market instruments. The maturity period of debt funds varies based on the scheme information document. Debt funds experience some amount of market volatility. 

How do Liquid Funds fare against other Investment Opportunities?

Following is a table pitting liquid funds again popular investment options such as Equity, Stock, and Fixed Deposit:

You may also like to read ELSS mutual funds.

You may also like to read How to invest in SIP mutual funds.