Liquid Mutual Funds

Touted as one of the best alternatives for bank savings accounts, liquid mutual funds offer capital protection and stable returns. They are a good option when you are looking to create an emergency fund or just want to keep your idle money aside in a safe instrument and get returns on it. In this article, we will be discussing what liquid mutual funds are, how they work, whether they are a good addition to your investment portfolio, the advantages of investing in them, and more.

Mutual funds are categorized based on asset allocation among other classifications. There are equity mutual funds, debt mutual funds, and hybrid mutual funds. Liquid mutual funds are debt mutual fund, which is widely loved by many investors to park their idle money. Get answers to all your burning questions about liquid mutual funds to make informed investment decisions.

Liquid funds are debt funds that invest in fixed-income securities such as certificates of deposit, treasury bills, commercial papers, and other debt securities that mature within 91 days. Liquid funds do not come with a lock-in period. These funds carry less risk and are considered to be the least risky among all classes of debt funds.

The reason they are less risky is that they mostly invest in high-quality fixed-income securities that are going to mature soon. Hence, these funds are suitable for risk-averse investors. Unlike some other funds, the Net Asset Value (NAV) of a liquid fund doesn't fluctuate much and that's why low duration high-quality securities make up these funds. If you wish to withdraw your investments from a liquid fund, the withdrawals are typically processed in 24 hours.

When you invest in a liquid mutual fund before 2 PM of a trading day, it will be processed as per the previous day's Net Asset Value (NAV), as long as the funds are credited to the asset management company's (AMC) collection account before 2 PM and the application reaches the AMC's branch before time. So, if a purchase transaction in a liquid fund is submitted on T day, the applicable NAV is of the day prior.

When you redeem your investments from the liquid fund, the redemption will be credited to your account on the next working day. For example, if you make redemptions on Friday before 3 PM, the redemption will be processed on Sunday’s NAV and the payout will happen on Monday.

The main source of earnings of a liquid mutual fund is via the interest income of its debt holidays and a smart portion of its income may be generated through capital gains. This means that when interest rates fall, bond prices go up and vice versa.

There are two investment modes through which an investor can invest in mutual fund schemes. They are

Lumpsum - You choose lump sum if you wish to invest one time in a mutual fund scheme. Usually, people choose this method when they receive a bonus, so they can put the money in a scheme as a one-time investment.

If you wish to know how much and how long you need to invest to achieve your goals, please check the Lumpsum Calculator, created by Koshex.

Systematic Investment Plan (SIP) - You choose SIP when you want to invest a fixed amount in a scheme at regular intervals. You can choose to invest ₹5000 every month or ₹10,000 every quarter. When the due date comes, your amount will be deducted automatically from your bank account and it will be used to purchase units of the mutual fund scheme.

If you wish to know how much you need to invest every month via SIP to achieve your goals, please check the SIP Calculator, created by Koshex.

Liquid mutual funds are suitable for the below types of investors and below situations.

Risk-Averse Investors - If you are someone who is risk-averse, you can choose to invest in liquid mutual funds, as they carry fewer risks than equity mutual funds. Liquid mutual funds invest in securities with lower tenure, as they are less volatile because the interest rate movement is more predictable in the long run. Hence, short-term securities provide interest close to the prevailing interest rate for a short tenure.

Investors Who Want To Build An Emergency Fund - You can use liquid funds to build your emergency fund. It is recommended to save six to 12 months of your income in your emergency fund. If you are someone who will spend your money if it stays in your bank savings account, you can consider investing it in liquid mutual funds. It is also highly liquid, making it easier to withdraw your investments whenever you need money. Most liquid funds do not have any exit load, so you can withdraw any day, without any penalty.

Investors With Short-Term Goals - If you have any short-term goals, liquid mutual funds would be a better bet as you can earn better returns on them. When we say short-term goals, we mean the goals you plan to achieve within one year, such as a family vacation or buying a gadget. The best way to achieve your short-term goals is by investing in liquid mutual funds via SIPs.

For Diversification - Liquid mutual funds are a great option for those investors who are looking to diversify their portfolio. If you have a goal, which needs to be achieved in just 3 months, you can consider investing in liquid mutual funds. Also, if your portfolio has a lot of equity instruments, you can consider investing a little portion of your money in liquid mutual funds to minimize your risk

Investors With Liquid Needs - Liquid mutual funds are suitable for investors who would require their money in the immediate future but also, don't mind staying invested for the short-term period. Even though the returns on liquid mutual funds are generally not as high as the return of other fixed-income funds, such as income funds, they do seek to offer stability and can therefore play a crucial role in your portfolio.

For Parking Funds - Investors can also use liquid mutual funds as a temporary holding place for assets while waiting for other investment opportunities to arise. Instead of keeping it in your savings account, you can invest in liquid mutual funds and earn better returns on them.

Better Returns - As mentioned before, liquid mutual funds earn higher returns than bank deposit rates. So, if you are willing to take a little bit of risk, you can consider investing in liquid funds.

Tax Benefits - Liquid funds follow debt taxation and their holding period is 3 years. When you redeem after 3 years, you get the benefit of indexation, which increases your purchase price. When your purchase price rises, your profits decrease. This helps you lower your tax payable.

High Liquidity - Liquidity refers to how quickly an asset can be converted into cash and liquid funds are highly liquid. If you redeem your investments from liquid funds, they will be processed in *T+1 day (*T = Transaction Day). For example, if you redeem on Friday, the redemption amount will be credited to you on Saturday. You can even redeem your investments from liquid funds after just investing for one day.

Low Exit Loads - Liquid mutual funds have exit loads of less than 7 days. This means you can redeem your investments from liquid funds without any penalties within just 7 days.

Low-Interest Rate Risk - We all know that debt funds carry interest rate risk. However, liquid fund papers mature within 91 days. Hence, they are not heavily affected by interest rate fluctuations. The NAV of liquid funds fluctuates very less compared to equity funds.

Perfect For STP - Liquid funds are a good option if you are considering doing a Systematic Transfer Plan into equity funds. In an STP, a fixed amount will be transferred from a liquid fund to an equity fund to achieve cost-averaging. You can also earn higher returns on the liquid fund balance.

Low Expense Ratios - Since liquid funds carry very low expense ratios, they offer higher returns.

Minimum Investment - Liquid funds are easier on the pocket than bank fixed deposits. If you start a bank FD, you would need to invest a minimum of ₹5000. However, you can start investing in a liquid fund with just ₹100.

Flexibility - Liquid funds come with growth and dividend options. If you are looking for capital appreciation, you can choose the growth option. Meanwhile, if you want regular income, you can choose the dividend option. However, dividends are taxable when it reaches you. So, if you fall under the highest tax bracket, you might end up paying more tax when you choose the dividend option.

Before we invest in any investment instrument, we should consider certain factors. Below are some of the factors that you should consider before putting your money into liquid mutual funds.

Objectives Of The Fund - Liquid funds are the least risky among all classes of debt funds because the NAV doesn't fluctuate too frequently because the assets the fund has invested in have a maturity period in the range of 60 days to 91 days.

But, the thing you should remember is there might be a chance of a sudden drop in NAV because of an abrupt fall in the credit rating of the underlying security. The moral of the story is that risk funds are not completely risk-free but they are safer than other types of mutual funds.

Risk Involved - Although liquid funds are touted as an alternative to FDs, they are a tad bit risky as the returns are not guaranteed. However, due to their low duration and short maturity as compared to other funds, they are less sensitive to changes in interest rates. So, even if they are not completely without any risk, the top liquid mutual funds carry very minimal risk.

Returns - Historically, liquid funds have offered returns in the range of 7% to 9%, which is higher than the 3.5% interest provided by a regular savings bank account. However, returns are not guaranteed.

Investment Cost - Like every other mutual fund, liquid funds also attract a fee, called an expense ratio. Liquid funds maintain a lower expense ratio to provide comparatively higher returns over a short period.

Expense Ratio - Investors must understand the costs involved in investing in liquid mutual funds. The expense ratio is the amount charged by fund houses for managing the fund. SEBI has marked the upper limit for this at 2.25% of the average asset under management. If a fund has a lower expense ratio, you will earn higher returns. So, it is important to choose a fund that has the lowest expense ratio.

Investment Horizon - You should only invest in liquid mutual funds if you have a short-term investment horizon but you can slowly transfer the amount to an equity fund if you wish to earn higher returns and have long-term goals.

Liquid mutual funds are subject to short-term and long-term capital gains tax.

Short-Term Capital Gain (STCG) Tax

If you withdraw your investments before 3 years, you have to pay STCG as per the income tax slab of the investor. For example, if you earn ₹50,000 by investing in liquid funds,₹50,000 are added to your income tax slab of the investor and taxed accordingly.

Long-Term Capital Gain (LTCG) Tax

If you withdraw your investments after 3 years, your long-term capital gains are taxed at 20%, with the benefit of indexation. (Indexation means that the purchase price is increased to adjust for inflation before calculating the capital gain).

Liquid mutual funds are a good investment option if you are looking to earn higher returns on your idle money. You can also use liquid mutual funds as a temporary place to hold your extra money while you wait for other investment opportunities. If you received a cash bonus or a cash gift on any occasion, you can consider investing them in liquid funds instead of keeping them idle in your bank account.

We hope this article helped you understand all about liquid mutual funds and how they can help you earn higher returns on your extra money. It is important to learn how liquid mutual funds will benefit you and what factors you should consider before investing in them.

If you wish to learn more about other types of mutual funds, including ELSS funds, and other types of investment instruments, such as Fixed Deposits, Digital Gold, and Smart Deposits, head over to our Blogs section. You can also check out our Calculators, where you can learn more about how much wealth you can accrue in certain years.

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