Liquid Funds - Defination, Risks, & Returns

Additionally, he makes sure that the portfolio's average maturity is kept to a maximum of 91 days. A fund with a shorter maturity is less susceptible to fluctuations in interest rates. The fund management tries to provide higher returns by aligning the maturity of individual assets with the portfolio's maturity. It's well known that liquid funds yield higher returns than a traditional savings account.

Factors to Consider Before Investing in Liquid Fund

The various factors that one should consider before investing in liquid fund are mentioned below -

1. Investment plan - Many investors use liquid funds to set up money for emergencies. They are as liquid as savings account deposits and provide respectable yields at reduced risks. Those with a three-month investment horizon are the target audience for these ETFs. Therefore, make sure you construct an investment plan in accordance with this before investing in these funds.
2. Risks - The underlying assets of a liquid fund are not very volatile because their maturity is up to 91 days. As a result, the fund's NAV stays relatively constant. Liquid funds are hence low-risk investments. It is crucial to remember that the NAV may also decline if the credit rating of any underlying securities declines. Funds that are liquid are not risk-free.
3. Expense ratio - Liquid funds require an annual fee for fund management services, much like all other mutual fund schemes. This is known as the expense ratio, and it represents a percentage of the fund's total assets.
   1. Most debt investors choose funds with a lower expense ratio since it maximises their profits. Furthermore, the majority of liquid fund managers make investments and keep the securities until they mature. As a result, the fund has a low expense ratio since it does not incur expenses from excessive securities buying and selling.
4. Returns - A cursory examination of liquid fund performance will reveal that these funds often yield returns between 7 and 9 percent. Therefore, they outperform the 4% yielded by savings account deposits.

Features of Liquid Funds

1. They feature a low annual fee between the range of 0.30% to 0.70%.
2. The minimum investment for liquid funds will vary with different schemes.
3. No entry and exit load.

Benefits of liquid funds

• No Lock-in Period - They are known as liquid funds as they have no lock-in period and give you quick access to the cash by redemption.
• Quick Withdrawals - Liquid fund withdrawals take place in a very short time, usually within 24 hours.
• Lowest Interest Rate Risk - Given that liquid funds mainly invest in fixed income securities which have a short maturity period, they have one of the lowest interest rate risk as compared to other debt funds.
• Tax Benefits - Liquid Funds offer valuable tax benefits.
• Comparatively Good Returns - Liquid funds offer an average return of about 8% per annum.

Is Income From Liquid Funds Taxable?

Capital gains from liquid funds are subject to tax. In case the funds are sold within three years (36 months), they will attract short-term capital gains tax. The rate of tax will be determined based on the income tax slab under which the individual falls. In case the funds are sold after three years, they will be subject to long-term capital gains tax which will be levied at 20% with the benefit of indexation.

Who Should Invest in Liquid Funds?

Liquid funds are great for people who -

1. Have short term investment goals - Given that they make investments in assets with similar maturities, liquid funds are most appropriate for investors with a maximum investment horizon of three months. To increase their returns, investors with longer investment horizons—say, six months to a year—should put their money into funds with somewhat longer durations—say, ultra short duration funds.
2. Want to maintain contingency fund - Liquid funds are meant to produce higher-than-fixed-deposit returns while offering safety and liquidity. As a result, investors can place a corpus for emergencies or contingencies in a liquid fund and be sure it will be secure and returned when needed.
3. Want to invest in bank deposit - Liquid funds provide investors who choose to keep their excess money in bank deposits two advantages: higher yields and more flexibility when it comes to withdrawals. Traditional bank fixed deposits have specified periods for which money is locked in, and early withdrawals are subject to interest penalties. Liquid funds, on the other hand, provide convenient exit choices and variable holding periods. Bank savings accounts allow you to take money out whenever you want, but the interest rate is only 3% to 4%, which is less than the 5% plus that a liquid fund typically yields.

Risks and Returns Associated with Liquid Funds

All the investments made in liquid funds, similar to investments in other mutual funds, are made in securities which come with a market price. The NAV (Net Asset Value) of your mutual funds increase or decrease based on the securities' market price. However, the NAV of a liquid fund doesn't increase or decrease as drastically as other funds.

According to SEBI (Securities and Exchange Board of India), in case a security matures within 60 days, it does not have to be marked to market. Only the interest component will have to be added.

Basically, the amount of interest earned by the debt fund via a security's tenure will equally divide the overall interest component for the number of days the security is held. The price of the security shall stay steady. Therefore, the movement of the NAV of the liquid fund will be linear. This does not mean that the liquid funds are free of risk.

The fund can make investments in scrips with maturity periods of up to 91 days. Thus, if investments are made in scrips with maturity periods ranging from 60 to 91 days, they will have to be marked to market based on their credit rating. In case there are defaults by underlying companies on the principal and/or interest repayment, the credit rating of the scrip will decline along with its market price.

In case investments from your liquid fund have been made in such securities, the NAV of the fund will decline too.

What is so special about liquid funds?

Liquid funds usually take just one day to process the encashment of funds. Thanks to the advancement in technology, however, you can soon get all your money in just a few minutes. However, the limit on the amount you can take out has been set at 90% of the value of your portfolio, or Rs.50,000 per day, whichever is less.

Liquid Fund Plans Available

Different plans like monthly dividend plans, weekly dividend plans, daily dividend plans and growth plans offer liquid funds. Investors are free to chose a plan as per their financial needs in term of convenience and liquidity. Retail investors are also free to invest in direct plan which feature a lower expense ratio. This helps yield higher returns.

Disclaimer

Mutual Fund investments will be subject to market risks. Any mutual fund listed in the document does not guarantee fund performance or its underlying creditworthiness. Do read the mutual fund document thoroughly before investing. Specific investment needs and other factors have to be taken into account while designing a mutual fund portfolio.

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