Understanding The Difference Between Liquid Funds and Liquid ETFs

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Liquid funds and liquid ETFs offer investors access to relatively low-risk, short-term investment opportunities. Both instruments cater to investors seeking liquidity, stability of capital, and modest income potential. However, they differ in their structure, management style, and accessibility.

This article explores the nuances of liquid funds and liquid ETFs.

  • Table of contents
  1. Investing in liquid funds
  2. Investing in liquid ETFs
  3. How liquid funds and liquid ETFs generate returns
  4. Comparison of returns by liquid ETFs and liquid funds
  5. Which is better – liquid funds or liquid ETFs

Investing in liquid funds

Liquid funds are mutual funds that primarily invest in short-term debt instruments such as treasury bills, commercial papers, and certificates of deposit with maturities of up to 91 days. These funds are designed to provide investors with reduced risk to the principal and a high degree of liquidity, while offering a steady, modest income potential.

Thus, liquid funds can empower your idle funds to generate slightly higher returns compared to bank savings accounts while ensuring almost comparable liquidity and relative stability. Moreover, you do not need a demat account to invest in liquid funds. Investments can be made through a distributor or directly via various financial portals and apps.

Investing in liquid ETFs

Liquid ETFs, on the other hand, are exchange-traded funds that invest in a basket of relatively low-risk debt securities, mostly with overnight maturities. However, unlike liquid mutual funds, ETFs are traded on stock exchanges like individual stocks, allowing investors to buy and sell units throughout the trading day at market prices. Therefore, unlike liquid mutual fund investments, you need to have a demat account for investing in liquid ETFs.

How liquid funds and liquid ETFs generate returns

Only a small proportion of earnings are generated from capital gains. The main source of earnings in liquid funds and liquid ETFs is from interest payouts. Additionally, since both are essentially debt instruments, their performance is closely linked to the interest rate environment.

When interest rates rise, the underlying bond prices fall, and vice versa. However, the shorter the duration of the bond, the lesser the impact of interest rate changes on its yield. Since liquid funds and liquid ETFs comprise underlying bonds of relatively shorter durations, they are minimally affected by interest rate changes.

Comparison of returns by liquid ETFs and liquid funds

Liquid funds and liquid ETFs are not growth oriented instruments. Their priority is mitigation of risk to principal, modest income potential, and high liquidity. Since both invest in securities with short maturities, their value is relatively stable across different interest rate cycles.

However, the return potential of either depends on the underlying assets. For instance, a liquid ETF that invests primarily in bonds with overnight maturities will carry a relatively lower risk and lower return potential compared to a liquid funds that invests in bonds with maturities of up to 91 days.

Moreover, the real returns from either investment also depend on factors such as the expense ratios, brokerage charges, and tax implications. Let’s discuss these factors and enable you to make an informed investment decision.

Which is better – liquid funds or liquid ETFs? (detailed difference)

Structure and management

Liquid funds: Managed by mutual fund companies, liquid funds pool investors' money to invest in a diversified portfolio of short-term debt instruments aligned with the objectives of the scheme.

Liquid ETFs: Managed by mutual fund companies, exchange-traded funds that trade on stock exchanges like individual stocks. Liquid ETFs in India generally seek to maintain a stable NAV through an IDCW strategy that allows investors to receive periodic dividend payouts arising from capital gains/ interest earnings. However, some liquid ETFs automatically reinvest the payouts back into the scheme and give investors additional “fractional units” in return. These fractional units cannot be sold on exchanges, but investors can sell them back to the fund house via brokers.

Trading and liquidity

Liquid funds: Purchased and redeemed directly from mutual fund companies at the end-of-day NAV. Liquid funds offer daily liquidity, allowing investors to withdraw their investments within one business day.

Liquid ETFs: Bought and sold on stock exchanges throughout the trading day at market prices. Liquid ETFs offer intraday liquidity, enabling investors to execute trades in real time and potentially take advantage of price movements during market hours.

Cost and expenses

Liquid funds: Typically have higher expense ratios compared to liquid ETFs due to administrative costs and management fees associated with mutual funds. Liquid funds may also charge exit loads, although these are minimal for most liquid funds.

Liquid ETFs: Tend to have lower expense ratios compared to mutual funds, making them a relatively cost-effective option for investors. However, investors may incur brokerage charges when buying and selling ETF units.

Conclusion
Both liquid funds and liquid ETFs offer investors access to short-term, low-risk investment opportunities with a focus on liquidity and limited impact on capital invested. While liquid funds are managed actively by mutual fund companies and offer daily liquidity, liquid ETFs trade on stock exchanges and provide intraday liquidity with relatively lower expense ratios. However, it's essential for investors to conduct thorough research and consider their individual circumstances before making any investment decisions.

FAQs

Can I redeem my investment in liquid funds and liquid ETFs at any time?
Yes, you can redeem your investment in liquid funds at the end of each trading day at the prevailing NAV. Meanwhile, in liquid ETFs, you can buy or sell units daily during market hours.

Are liquid ETFs more suitable for short-term or long-term investments?
Liquid ETFs are more suitable for short-term horizons. For example, investors who want to park surplus funds while earning a higher interest payout compared to traditional bank savings accounts can consider liquid funds.

How do the expense ratios of liquid funds and liquid ETFs compare?
The expense ratios of liquid ETFs are generally lower than those of liquid funds due to their passive management structure. However, trading liquid ETF units may attract brokerage charges.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.