Every investor who invests in Liquid Funds (A Liquid Fund is a type of debt fund, which has the least interest rate risk and reduced levels of credit risk), expects to protect their capital and also make a reasonable rate of return ahead of inflation.
One can reasonably expect about 2% pa return over and above inflation from liquid funds, based on historical data.
The question is whether this is a rational expectation. Can the investor hope to have such expectations in the future?
Here is the data.
Going back to 2000-01, we took the average returns of the Top 5 liquid fund in each of the years. We then compared this to the CPI Inflation (Consumer Price Inflation). The difference is commonly referred to as the ‘real rate’ of return.
- On average, liquid funds have delivered 2.0% pa more than inflation over the past 19 years.
- These incremental returns fall down to nil if one were to have paid tax on the liquid fund returns.
- In FY2018-19, liquid funds delivered 7.8% pa return, compared with a CPI inflation of 2.5%. The incremental return of 5.3% in FY2019 is the highest ever witnessed since FY2000.
- There have been 3 years, in the past 19 years, where liquid fund returns have been less than inflation, but these are outlier years as some of the periods saw some structural constraints.
- One can reasonably expect about 2% pa return over and above inflation from liquid funds, based on historical data.
- If your holding period is less than three years, all the incremental returns will be eaten away by taxes.
- If you hold for more than three years, and take indexation benefit, you can expect to make some returns over inflation.
- ‘Real returns’, as seen in FY2019, are probably not sustainable based on historical evidence.
For shorter holding periods, liquid funds should protect capital and provide an avenue to easily invest and withdraw your money as per your requirements. On the other hand, the investments after taxes are unlikely to beat inflation. If you hold the same for more than 3 years, and benefit from indexation, you can expect to beat inflation by about 1%.