What Are Liquid Funds? Definition, Advantages and Example

New investors might often wonder, “What is liquid a fund?”. A liquid fund mutual fund invests in debt and money market securities with a maturity of up to 91 days. They are considered to carry low to moderate risk and may offer relatively better return potential than a regular savings account*. Liquid funds are often utilised by investors to park their surplus funds for a short period.

Table of contents

• What is liquid fund
• Step-by-step process to invest in liquid funds
• Factors to consider before investing in liquid funds
• Who should invest in liquid mutual funds?
• Major advantages
• Example of liquid fund
• How do liquid mutual funds work?
• Inflation risk in liquid funds
• Evaluating the risk and returns of liquid funds
• What to consider or strategies for managing inflation risk in liquid funds
• How to invest in liquid funds?
• How liquid funds contribute to portfolio stability

What is liquid fund?

A liquid fund is a type of mutual fund that primarily invests in money market securities and debt instruments with a maturity of up to 91 days. These funds are designed to maintain relatively low risk, provide liquidity, and offer potentially stable returns.

The meaning of liquid funds lies in their ability to invest in instruments that can be quickly converted into cash, including treasury bills, commercial paper, and other short-term instruments.

Liquid funds may be suitable for individuals and corporates managing short-term cash flows. They may also be considered as alternatives to traditional savings accounts for investors seeking short-term, relatively low-risk investment options.

Additionally, liquid funds may help investors park funds for emergency needs or until suitable investment opportunities arise in other asset classes.

To summarise, liquid funds can serve as a suitable investment option for those prioritising liquidity, relatively low risk, and potential stability in returns.

Read Also: Liquid funds vs fixed deposits

Example of liquid fund

A liquid fund is a type of debt mutual fund that invests in short-term money market instruments.

Suppose you invest Rs. 1,00,000 in a liquid fund. The fund allocates this money into instruments maturing within 91 days, such as a commercial paper issued by a highly rated company or short-term government securities. If the average return is around 5% annually, your investment may grow to about Rs. 1,05,000 in a year.

*For illustrative purposes only.

How do liquid mutual funds work?

Liquid mutual funds function by investing in short-term debt and money market instruments. Here’s how they operate:

• Investment in short-term instruments: These funds primarily invest in securities maturing within 91 days, such as treasury bills (T-bills), commercial paper (CPs), certificates of deposit (CDs), and other short-term debt instruments.
• Net asset value (NAV): The NAV reflects the per-unit market value of the fund’s assets after deducting liabilities. It fluctuates based on changes in the market value of the underlying securities.
• Fund management: A professional fund manager oversees the portfolio, making investment decisions in line with market conditions and the fund’s objectives.
• Redemption: Investors can redeem units at the prevailing NAV, with the redemption process being relatively quick and efficient.

Step-by-step process to invest in liquid funds

Now that you have understood what a liquid mutual fund is, let’s look at how you can invest in it. Investing in liquid funds can offer a straightforward way to park surplus funds while aiming for relatively stable returns.

1. You can invest through distributors or online platforms offering liquid funds. Many Asset Management Companies (AMCs) provide a smooth, guided investment process through user-friendly portals.
2. Register on your chosen platform by providing your details. This typically includes PAN, Aadhaar for KYC verification, and bank details.
3. Explore the various liquid funds available, along with their historical performance and risk indicators, and choose one that aligns with your financial goals. Selecting an appropriate scheme may help you work towards your financial objectives.
4. Decide the amount you wish to invest. Liquid funds generally do not have a lock-in period, offering flexibility to redeem subject to applicable terms.
5. Click on the ‘invest’ or ‘buy’ option to purchase the desired fund and follow the instructions.
6. If you wish to invest regularly, you can set up a Systematic Investment Plan (SIP), which allows you to invest a fixed amount at regular intervals.

Once the payment is processed, the units of the fund will be reflected in your account. You can track the performance of your investment through the platform dashboard.

Factors to consider before investing in liquid funds

Before investing in liquid funds, it is important to evaluate whether they align with your financial goals and risk tolerance. These funds typically invest in short-term debt instruments and may offer relatively low risk, modest return potential, and liquidity:

• Liquidity: One of the main reasons for choosing a liquid fund investment is its high liquidity. However, it is important to review the average maturity period and the assets where the fund has invested to gauge its liquidity.
• Investment horizon: Liquid funds are generally suited for short-term goals or when you have surplus cash that you might need soon.
• Returns: While liquid funds may offer relatively better return potential than a savings account, the risk associated may be slightly higher. Review past performance, but remember that past returns do not guarantee future performance.
• Exit load: Liquid funds may have an exit load, which is a fee charged if you withdraw your investment within a specified period. Always check for any such conditions.

Returns on fixed deposits/savings accounts are fixed, however, returns on mutual funds are subject to market risks

Who should invest in liquid mutual funds?

Liquid mutual funds can be suitable for individuals and businesses with specific financial requirements. Here are some potential investors:

• Individuals with short-term surplus funds: Those with extra money they may need in a few weeks or months can consider liquid funds. This includes individuals waiting for an investment opportunity or those looking to park emergency funds.
• Individuals managing cash flow: Liquid funds can help maintain financial flexibility by providing relatively easy access to funds, making them beneficial for cash flow management.
• Investors seeking relatively lower volatility: Compared to equity or longer-duration debt funds, liquid funds tend to experience relatively lower fluctuations, making them suitable for those prioritizing principal preservation over potentially higher returns.
• Those exploring alternatives to savings accounts: While savings accounts provide liquidity, liquid funds may offer the potential for slightly higher returns, though they come with market-related risks.
• Investors looking for a temporary holding option: Those planning to invest in equity or longer term debt funds can use liquid funds to prevent their money from remaining idle while finalizing investment decisions.

Major advantages of investing in liquid funds

Liquid mutual funds provide several potential benefits, mainly in terms of liquidity and relatively lower volatility. Here are some key advantages:

• High liquidity: A major advantage is the ease of redemption. Investors can usually withdraw their funds within one business day, making liquid funds suitable for short-term cash management.
• Relatively lower volatility: Compared to equity funds or longer-duration debt funds, liquid funds tend to have relatively lower fluctuations, which may appeal to investors prioritising capital stablility.
• Flexible holding period: Investors can stay invested in a liquid fund for any duration they choose. This makes liquid funds a suitable choice for those looking to maintain a contingency reserve.
• No exit load: Many liquid funds may not impose an exit load beyond a short initial holding period, allowing investors to redeem their investments without additional costs.

Inflation risk in liquid funds

One of the potential risks with liquid funds is that their returns may not always keep pace with inflation, especially in a high-inflation environment. Inflation is the increase in the cost of goods and services over time and erodes the purchasing power of money. If liquid fund returns are outpaced by inflation, then the effective value of these returns may reduce. For example, if the inflation rate is 7% but the post-tax return from liquid funds is only 6%, then the investor, in real terms, may effectively earn a negative return, meaning their money is losing value instead of gaining it.

Evaluating the risk and returns of liquid funds

Just like any other investment option, liquid mutual fund investment also carries some degree of risk. Thus, a thorough evaluation of the credit quality of the underlying securities held by the fund and the interest rate sensitivity is advisable. Mentioned below are some additional factors you must consider when selecting liquid funds:

• Portfolio quality: Evaluate the credit quality of the underlying securities held by the fund to gauge its risk level.
• Fund manager’s expertise: Consider the experience and expertise of the fund manager in navigating various market cycles.
• Fund size and liquidity: A well-sized fund with sufficient liquidity may help facilitate ease of entry and exit without significantly impacting the fund’s stability.
• Taxation on gains: Liquid funds are taxed as debt funds. Gains from debt funds are taxed as per the investor’s applicable income tax slab rates..

What to consider or strategies for managing inflation risk in liquid funds

Given this risk, investors need to factor in inflation while setting return expectations from liquid funds. Some strategies to help manage inflation risk include the below:

• Select liquid funds that actively manage credit risk to optimise the return potential during inflationary periods.
• Diversify into instruments like inflation indexed bonds and floating rate bonds.
• For long-term goals, consider allocating some funds to equity mutual funds which have historically delivered inflation-beating returns over 7-10 years.
• Build an emergency corpus that covers 6-12 months of essential expenses, so you don’t have to withdraw invested capital during unforeseen circumstances.
• Revisit investment goals in line with expected inflation and modify allocations accordingly to help maintain purchasing power.
• Keep track of inflation trends and interest rate cycles to make informed investment decisions.

How to invest in liquid funds?

Investing in liquid mutual funds is a relatively simple process. Here are the common methods:

• Through mutual fund distributors: Investors can invest via registered mutual fund distributors or financial advisors who provide guidance and assist with the application process.
• Directly through asset management companies (AMCs): Many AMCs allow direct investments through their websites or mobile apps. This option can potentially help investors save on distributor commissions.
• Online platforms: Various online platforms and mobile apps facilitate mutual fund investments. These platforms provide an easy way to compare and invest in different liquid funds.

Steps involved

1. KYC compliance: Ensure KYC requirements are met, as they are mandatory for all mutual fund investments.
2. Choose an AMC or platform: Select a suitable AMC or online platform for investment.
3. Select a liquid fund: Research and choose a liquid fund that aligns with financial objectives, considering factors such as the expense ratio and historical performance.
4. Make the investment: Decide on the investment mode (lumpsum or SIP) and proceed with the payment.

How liquid funds contribute to portfolio stability

Liquid funds provide relative portfolio stability through several important benefits:

• Lower volatility: Liquid funds primarily invest in short-term debt instruments with relatively low credit risk, resulting in relatively lower volatility compared to asset classes like equities. This may help reduces overall portfolio fluctuations, particularly during market declines.
• Emergency fund support: Liquid funds can be a suitable option for building an emergency fund. Their high liquidity may enable relatively quick access to funds during unforeseen situations like job loss, medical expenses, or unexpected costs, potentially helping investors avoid selling long-term investments under unfavourable conditions.
• Temporary cash management: Liquid funds offer a relatively stable way to temporarily hold surplus cash.

Conclusion

Liquid mutual funds can be a suitable option for investors looking for high liquidity and relatively lower volatility for short-term investments. They may offer the potential for relatively better returns than traditional savings accounts while allowing easy access to funds. However, unlike savings accounts, returns are not fixed or guaranteed and depend on market conditions. Investors should assess their financial objectives and risk tolerance before investing and stay informed about the latest tax regulations on debt funds.

FAQs

How long should I stay invested in liquid mutual funds?

Liquid mutual funds can be suitable for parking of surplus cash, building an emergency reserve, saving for short-term goals etc. They provide relatively high liquidity, allowing quick access to your money. However, returns depend on market conditions. These funds, however, do not typically offer the potential for inflation-beating returns in the long term.

Where do liquid mutual funds invest?

Liquid mutual funds primarily invest in short-term debt instruments such as treasury bills, commercial papers, and certificates of deposit, with maturities of up to 91 days. Their objective is to offer high liquidity and relatively stable returns that align with money market rates.

Who should invest in liquid funds?

Individuals or entities with surplus funds that they need to park for a short period can consider a liquid fund mutual fund. These may include those looking to park emergency funds, businesses managing temporary cash surpluses, or investors waiting to allocate funds elsewhere.

How much return can you expect from liquid funds?

Liquid fund returns are influenced by prevailing market conditions and interest rates. They have the potential to offer better returns than savings accounts, but returns are not guaranteed and can fluctuate.

Are liquid funds better than a bank’s term deposit?

Liquid funds provide higher liquidity than term deposits, enabling quicker access to funds. While term deposits offer fixed returns, liquid fund returns may vary. The choice depends on individual priorities between liquidity or fixed returns.

Are liquid fund returns taxed?

Capital gains from liquid funds are taxed upon redemption. The gains are added to the investor’s taxable income and taxed as per their applicable slab rates.

What is liquid mutual fund?

Liquid mutual funds are short-term investments that typically have a maturity of up to 91 days or less. They are known for their high liquidity and can be a suitable option to park one’s money for a short duration. This is the meaning of liquid funds.

How can investors mitigate inflation risk while investing in liquid funds?

Investors can partially mitigate inflation risk associated with liquid funds by diversifying into other low-risk debt instruments. Liquid funds should only form a part of one’s overall portfolio with investments also made in short duration bond funds with higher potential yields than liquid funds, inflation indexed bond funds and floating rate funds.

What factors contribute to the return potential of liquid mutual funds?

The return potential of liquid funds is influenced by several factors such as prevailing interest rates, fund manager’s expertise and any associated fees or expenses. Investors should evaluate these factors before investing in liquid mutual funds.

Are liquid mutual funds suitable for all investors?

Liquid mutual funds may not be suitable for all investors, as their return potential is influenced by factors such as prevailing interest rates, the fund manager’s expertise, and associated fees or expenses. Investors should evaluate their investment objectives and risk tolerance before investing.

How do liquid funds differ from other mutual funds?

Investment duration and risk profile are the factors that differentiate liquid mutual funds from most other types of mutual funds. Liquid funds focus on short term and highly liquid assets while most other types of mutual funds invest in a wide range of securities with varying risk profiles.