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Liquid Funds: Working and Benefits

  • Ayush Singh Rawat
  • Dec 03, 2021
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Mutual fund investing has become extremely popular among Indian investors. While mutual fund investing has attracted a large number of new investors, there are still a small number of individuals who do not invest in mutual funds. 


Many investors believe that investing in mutual funds is a long-term plan, and that if they do so, their money will be locked up and there will be no liquidity. 


Furthermore, they cannot access their funds in an emergency, and if they can, they will receive a poor return.


To avoid these obstacles, mutual fund investors might invest in a Liquid Fund. This attempts to give investors with high liquidity and capital security, i.e, the investor has total access to their money and may redeem them anytime they need it. 


What are Liquid funds?


Liquid funds are a type of debt fund that invests in money market instruments that provide short-term fixed-interest income. Treasury bills, commercial paper, and other underlying securities are examples of underlying securities in a liquid fund's portfolio.


Mutual funds that invest in assets with a residual maturity of up to 91 days are known as liquid funds. Liquid funds do not have a lock-in period, therefore assets are not locked up for a lengthy time.


(Related reading: Mutual Fund in India)



Characteristics of Liquid Funds


  1. Profit yielding


Investors who put their money in liquid funds are more likely to make a profit. When compared to the interest rates given by most savings accounts, they pay a greater rate of interest.



  1. Earned Dividends


A tax known as the dividend distribution applies to dividends that investors might earn through liquid investments. Even after taxes, the dividends earned by liquid funds investors outperform the profits given by savings accounts.



  1. The Tax System


Investors in liquid investments benefit from tax advantages. Long-term profits are subject to a 20% tax rate, which includes indexation. 


Short-term capital gains, on the other hand, are added to an investor's income and taxed at the standard rate at the time, based on the investor's tax bracket.



  1. Adaptability


Investors have the option to withdraw money anytime they need it. When investors have additional cash on hand, they might invest a large sum in liquid funds at the same time. 


Liquid fund investments are even more flexible because there is no set minimum investment horizon.



How do liquid funds work?


A liquid fund seeks to invest in financial products that are often short-term, highly reputable, and offer strong liquidity. As directed by SEBI, it exclusively invests in listed securities and commercial documents. SEBI forbids it from investing in hazardous assets since it must keep credit risk under control.


Typically, 20% of assets are invested in liquid goods to allow for quick cash redemption demands from investors. Liquid funds make returns mostly from interest collected on debt assets, with a modest amount of income from capital gains.


As liquid funds invest in short-term assets, interest rate movements have little impact on their market value. As a result, the capital amount suffers small losses or profits. 


As interest rates rise, the liquid fund's revenues rise but capital losses are minimal. As a result, these funds are considered low-risk.


Liquid funds are a great way to put your money to work rather than letting it sit in a bank account. It is an excellent choice to explore since you have the flexibility to liquidate your investment as needed while still receiving consistent profits as explained by Cleartax.



10 Benefits of liquid funds


  1. Better Returns: 


Mutual funds have a track record of outperforming bank savings in terms of returns. Bank deposit rates have dropped dramatically in the previous ten years. However, the return on liquid money has remained consistent at 7 to 7.5%.



  1. Tax Advantage: 


Liquid money is taxed in the same way that debt is. They have a three-year holding period. You obtain the advantage of indexation when you redeem after three years. 


Indexation raises the cost of your purchase. Your profits will fall as your purchasing price rises. This reduces the amount of tax you owe.



  1. Low-Risk: 


Liquid mutual funds invest in short-term securities with maturities of fewer than 91 days. These papers are AAA rated and have a low chance of default. 


Strong private or public enterprises, as well as the government, typically issue them. As a result, liquid money poses extremely minimal financial risk.



  1. Individual Fixed Income Market Participation: 


Liquid funds allow retail investors to engage in the Indian fixed income market.


Previously, banks, insurance companies, pension funds, and other financial institutions controlled this industry. Ordinary investors were unable to participate in the fixed income market. 


Liquid funds, on the other hand, have enabled individual investors to engage in the fixed income market by pooling money from thousands of participants.



  1. Liquidity: 


Liquidity refers to the speed with which an asset may be changed into cash. Liquid funds are a type of mutual fund that is extremely liquid. 


T+1 day is the time it takes to process a redemption from liquid funds, the letter T stands for "transaction day." 


As a result, if you redeem on Friday, your redemption will be reimbursed on Saturday. You can also withdraw money from liquid funds within one day. There is no such thing as a lock-in period.

The image is depicting the multiple benefits of liquid funds.

Benefits of liquid funds

  1. Low Exit Loads: 


Debt funds are popular among investors, but their exit loads are significant. The exit load period for credit risk debt funds is 540 days. 


Liquid mutual funds, on the other hand, have exit loads of fewer than seven days. So, in only 7 days, you may withdraw money from liquid assets without incurring any penalties!



  1. Low Interest Rate Risk


Because liquid fund papers mature in 91 days, interest rate swings have little influence on them. Liquid funds' Net Asset Value (NAV) varies far less than equity funds.



  1. Real-time price discovery: 


On Saturdays and Sundays, the market price of equity funds is not available. 


On Saturdays and Sundays, however, the NAV of liquid funds is also available. Liquid mutual funds are the only ones whose NAV is determined for the entire year.



  1. Ideal for STP (Systematic Transfer Plan)


Liquid funds are also ideal for STP into equity funds. It is not advisable to make a lump sum investment in equity funds since it entails market timing. STP is favoured by regular investors to prevent lump-sum investment. 


A set amount is transferred from a liquid fund to an equity fund in a STP. You may achieve cost-averaging this way. You get better returns on your liquid fund balance as well.



  1. Low Expense Ratios:


Liquid funds are handled by professionals. Fund houses incur management fees, which are included in the fund's cost ratio, to manage the portfolio. 


The cost-to-income ratio and portfolio returns are inversely proportional. Expense ratios for liquid funds are quite low. As a result, they provide better returns.


(Recommended reading: What are Investment Funds and Their Types?)


Risks and Returns Associated with Liquid Funds


All of the investments made in liquid funds, like those made in other mutual funds, are made in securities with a market price. 


The market price of the securities determines the NAV (Net Asset Value) of your mutual funds. A liquid fund's NAV, on the other hand, does not fluctuate as much as other funds'.


If a security matures within 60 days, it does not need to be marked to market, according to SEBI (Securities and Exchange Board of India). It will only be necessary to include the interest component. 


In general, the amount of interest collected by a debt fund during the course of a security's lifetime divides the overall interest component evenly for the number of days the security is held. The security's price will remain stable. 


As a result, the liquid fund's NAV will move in a linear fashion. This is not to say that liquid money is risk-free.


The fund can invest in scrips that have a maturity of up to 91 days. As a result, if you invest in scrips with maturities ranging from 60 to 91 days, you'll have to mark them to market based on their credit rating. 


If the underlying firms fail to repay the principal and/or interest, the credit rating of scrips will suffer, and its market price will fall. If your liquid fund has made investments in such securities, the fund's NAV will drop as well.

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