Liquid Funds

A liquid fund is a category of debt mutual fund that invests in short-term debt and money market instruments with a maturity period of up to 91 days. The funds mainly invest in treasury bills, commercial papers, and certificates of deposits. Their portfolios may also include other high liquidity debt securities issued by governments, banks and corporations.

These funds are regulated by the Securities and Exchange Board of India (SEBI), which mandates that all underlying instruments must have a residual maturity of up to 91 days. This regulatory framework ensures liquidity while reducing interest rate risk.

The main aim of liquid funds is capital preservation and liquidity for investors looking for relatively stable and modest returns. Such funds do not invest in equities but solely in debt and money market instruments with high credit quality ratings.

Investors use liquid funds to park excess surplus funds for short durations, usually for a few days or even a few months. The net asset value (NAV) of liquid funds is computed for all 365 days of the year, including Sundays and public holidays, which enables the investor to track their investment on a daily basis. However, you cannot buy or redeem units on those non-business days.

How do Liquid Funds Work?

Liquid funds operate by pooling money from multiple investors and deploying this capital into short-term debt securities. The fund manager selects the instruments according to the credit quality, yield and liquidity requirements.

The investment process starts once investors buy units of a liquid fund. Allocation of units is done by the fund house depending on the relevant NAV. For liquid funds, SEBI allows the use of the NAV of the day preceding the next business day for redemption requests received before the cut-off time, which is typically 3:0 PM on business days. This mechanism ensures that investors receive predictable exit values.

Fund managers have a portfolio of the following debt instruments in order to diversify risk-

• Treasury Bills (T-Bills) are issued by the Indian government.
• Corporate Commercial Paper (CPs) issued by very high credit-rated companies.
• Certificate of Deposit (CD) issued by a scheduled commercial bank.
• Repo and reverse repo transactions.
• Government securities having residual maturity, which goes up to 91 days.

The returns generated by liquid funds come from the interest earned on these underlying securities. As the instruments mature, fund managers re-invest in new securities, which makes the portfolio short-term.

Redemption proceeds from liquid funds are generally credited within one business day (T+1). Many asset management companies also offer an instant redemption facility, allowing investors to withdraw up to ₹50,000 or 90% of the invested amount (whichever is lower) per day per scheme, subject to fund house policies and liquidity availability. This feature makes liquid funds suitable for emergency fund allocations.

Advantages and Disadvantages of Investing in Liquid Funds

Advantages:

• High Liquidity: Liquid funds are quick redemption funds. Redemption proceeds are generally credited within one business day (T+1). Additionally, many asset management companies provide an instant redemption facility that allows investors to withdraw up to ₹50,000 or 90% of the invested amount (whichever is lower) per day per scheme.
• Low Interest Rate Risk: Liquid funds invest in instruments with a residual maturity of up to 91 days, as mandated by the Securities and Exchange Board of India. The short maturity profile helps reduce sensitivity to interest rate movements compared to longer-duration debt funds.
• Relatively Low Credit Risk: These funds typically invest in high-quality money market and debt instruments such as Treasury Bills, AAA-rated securities, and A1+ rated Commercial Papers. While credit risk is lower compared to many other debt fund categories, it is not entirely eliminated
• No Entry or Exit Load: The majority of liquid funds have no entry loads. The exit loads usually apply only in case of a redemption made within the seven days of investment. Investors need to verify the applicable exit load structure in the SID.
• Higher Returns than Savings Accounts:Liquid funds invest in short-term interest-bearing instruments and have historically offered returns that are often higher than traditional savings bank accounts, though returns vary with market interest rates. Past performance does not guarantee future results.
• Computation of NAV daily: The Net Asset Value (NAV) of liquid funds is computed for all 365 days of the year, including weekends and public holidays. This provides transparency and allows investors to track their investment value daily (although transactions are processed only on business days).
• No Lock-in Period:Liquid funds do not have a lock-in period. Investors can redeem their holdings at any time, subject to applicable exit loads and cut-off time rules.

Disadvantages:

• Low Returns Compared to Other Debt Funds: Due to their conservative investment approach and short maturity profile, liquid funds generally deliver modest returns. The equity funds or long-term debt funds can yield better returns in the long term, but with a greater risk.
• Not completely Risk-Free: Liquid funds are not completely risk-free, and they are exposed to credit risk in case there is a default by an issuer. The returns may also be affected by a change in the interest rates, but the effect is minimal since the maturity period is short.
• No Guaranteed Returns: Liquid funds do not provide guaranteed returns, as is the case with fixed deposits. The real returns will be based upon the performance of the underlying securities and the current market environment.
• Impact of the expense ratio: Expense ratio is the annual fee charged by the fund house to manage the fund (including administrative and operational costs). Liquid funds have a lower expense ratio of 0.1 – 0.3% as compared to equity funds (1 – 2%). Lower expense ratios improve the net returns that the investor holds.

Who Should Invest in Liquid Funds

Liquid funds may be suitable for investors who-

• Have a short-term horizon for investment. Liquid funds may be considered by those investors who want to deposit their funds for a few days to a few months.
• Alternative to Idle Cash: Investors with surplus cash who seek better returns than traditional savings accounts, while maintaining liquidity.
• Maintain Emergency Funds: Some investors use liquid funds as part of emergency funds because they are relatively easy to redeem.
• Prefer Lower Duration Risk: Investors seeking to minimise interest rate risk compared to long-duration debt funds.

Liquid funds might not be appropriate for the investor who wants to enjoy a long-term increase in capital or those who have the ability to assume the risk associated with the equity market in order to earn better returns.

How to Invest in Liquid Funds

To invest in liquid funds, the following steps are followed:

1. Complete KYC

Know Your Customer (KYC) formalities have to be completed by investors in accordance with the requirements of the Securities and Exchange Board of India (SEBI).

2. Choose a Fund

The investors should review the scheme documentation, which includes the Scheme Information Document (SID), Key Information Memorandum (KIM) and portfolio disclosures. Parameters like expense ratio, portfolio quality, assets under management (AUM) and historical volatility could be assessed.

3. Select Investment Mode

Investors can invest-

• Through a lump sum
• Through a Systematic Investment Plan (SIP).
• Invest Through a Platform

The liquid funds can be accessed through-

• Mutual fund direct platforms.
• Registered stockbrokers
• Websites of the Asset Management Company (AMC).
• Registered Transfer Agents and Registrar (RTAs).

4. Monitor Portfolio

Although liquid funds are short-term instruments, investors should periodically review the portfolio credit quality and fund performance relative to category averages.

Factors to Consider While Investing in Liquid Funds

Some of the factors to be considered by investors before investing in liquid funds are:

1. Credit Quality of Portfolio

Credit risk depends on the proportion of high-rated instruments (such as AAA-rated securities) versus lower-rated instruments. An increase in credit quality generally reduces default risk but may offer comparatively lower yields.

2. Expense Ratio

The expense ratio represents the annual fee charged by the fund house for managing and operating the liquid fund. It is deducted from the fund’s assets and directly affects the net returns earned by investors. A lower expense ratio generally allows a larger portion of the fund’s returns to remain with investors. Comparing the expense ratios of similar liquid fund schemes can help in understanding the cost efficiency of a fund.

3. Fund Size and Assets under management (AUM)

Fund size refers to the total value of assets managed by the scheme, commonly known as Assets Under Management (AUM). Funds with a larger AUM may benefit from greater diversification across securities and may have better access to issuers in the market. However, very large funds may sometimes face challenges in deploying capital efficiently. Therefore, it is useful to compare a fund’s AUM with that of similar schemes rather than evaluating it in isolation. A fund whose size is broadly aligned with its peers is often considered more manageable for effective portfolio management

4. Portfolio Composition

Examine the instruments that the fund invests in to check if it diversified across government securities, commercial papers, as well as certificates of deposits. Assess concentration risk in specific sectors or issuers.

5. Average Maturity

SEBI mandates a maximum residual maturity of 91 days for individual securities. However, funds may maintain varying average maturities for their overall portfolio within this limit. A shorter average maturity typically indicates lower sensitivity to interest rate changes, though this may result in marginally lower yields.

6. Historical Returns

Past performance across different time periods (e.g., 1 month, 3 months, 6 months, 1 year) can provide insights into fund behavior but does not guarantee future results. Performance should be evaluated alongside risk and portfolio quality.

7. Exit Load Structure

Many liquid funds levy exit loads if the redemption is made within seven days. Exit load conditions differ across funds, so investors should review the specific terms before redeeming their investments.

8. Instant Redemption Facility

Some liquid funds offer instant redemption features, subject to limits. This feature can enhance liquidity, particularly for emergency fund requirements. Investors should check redemption limits and availability.

9. Fund House Reputation

The reputation of the asset management company, the past track record of regulatory compliance, and the efficiency of the company’s operations influence investor experience. Well-developed fund houses that have good governance structures offer better reliability.

Taxation on Liquid Funds

The liquid funds fall under the debt fund category and are taxed accordingly. Units purchased before 1st April 2023 and held for 24 months or less shall be considered as short-term gains and taxed at the investor’s income tax slab rate. If the units are held for more than 24 months, they attract LTCG tax @12.5% without indexation.

For units purchased after 1st April 2023, the holding period clause no longer applies. The fund gains will be considered short term capital gains and taxed at the investor’s income tax slab rate, irrespective of the period of holding.

Conclusion

Liquid funds offer a blend of liquidity, capital preservation, and modest returns, making them ideal for short-term surplus deployment. They deliver higher potential than savings accounts. But investors need to be aware of the associated credit and interest rate risks. These funds work well for parking cash temporarily with immediate liquidity potential. A careful evaluation of expense ratios, portfolio quality and exit load structures is needed before investing.