Liquid funds are a popular investment choice for many, especially for those who want to create an emergency fund, or save for their short-term goals such as taking a vacation or their children's education. Liquid funds can provide better returns than a savings bank account and can be easily liquidated as well, making them an attractive cash management tool. Unlike equity funds in a volatile market, or long-term debt funds that react sharply to interest rate fluctuations, liquid funds tend to be stable and are often seen as a smarter alternative to fixed deposits.
What Are Liquid Funds?
Liquid funds are a form of debt mutual funds. They typically invest in short-term debt instruments such as treasury bills, commercial papers, FD, and other debts with low maturity durations. The tenure of the underlying securities is typically up to 91 days. Liquid funds are seen to be the lowest risk mutual fund, and they have provided long-term returns ranging from 6-9% per annum in the recent past. For a risk-averse investor with surplus cash, liquid funds are a good short-term bet as they do not come with a lock-in period, can be liquidated instantly, provide moderate returns at very low risks, and allow you to get more out of your cash reserves.
A liquid fund can be easily redeemed with a value close to a pre-determined range. This gives an investor a fair idea about an approximate amount that he will get after maturity. Also, the uncertainty in redemption value for a liquid fund is lowest as compared to equity funds and the redemption order is processed within 24 hrs, unlike in equity funds, which takes two days. Since the fund invests in short-term debt instruments, there is very low sensitivity to interest rate fluctuations which make debt funds of longer duration volatile.
There is no exit load on liquid funds, and the only charge is the total expense ratio. These are open-ended funds so you can enter and exit your liquid fund investment as you please.
Investing In Liquid Funds
Most mutual funds AMCs (Asset Management Companies) offer liquid fund products. It would be wise to compare various funds available in the market before taking a call for yourself. While assessing a liquid fund, assess its performance and expense ratio.
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For investing in liquid funds, you can apply online on their website, or visit their office and fill up the required forms to complete your KYC. If your KYC is done, you don’t need to do it again. KYC-compliant investors can start investing through online platforms as well. You can also consult mutual fund advisor, or use your demat account for investment through your stock trading account.
Why Liquid Funds
Liquid funds are a low-risk investment that provides capital gains at roughly the same rate interest rate is earned on fixed deposits for various tenures. Therefore, this is ideal for investors who have a short term financial goal. For example, if you have Rs 5 lakh idle cash which you may need after three months, you can consider parking this money in liquid funds as you may earn a return of 6% to 8% per annum (depending on the prevailing interest rate on debt instruments in the market) on this amount. You will earn a lower interest rate if you keep this money in a current or savings bank account. If you invest it in fixed deposits, you will have to pay TDS if the total interest earned exceeds Rs 10,000 in a financial year. Capital gains on mutual funds are taxable only in the year of redemption, and therefore you do not need to pay taxes on gains made where your investment hasn't been liquidated.
Liquid funds attract taxes on both long term capital gains (LTCG) and short term capital gains (STCG) depending on the investment period. If the fund is held for more than three years, your gains will attract long term capital gain tax (LTCG) at the rate of 20% with indexation benefit. If it is redeemed within three years of investment, the investor has to pay short term capital gain (STCG) tax at the rate of his or her tax slab.
What You Need To Keep In Mind
Liquid funds are ideal for short-term goals no longer than a year. Invest only the amount which you may need soon. They're not suited for wealth creation. If your objective is wealth creation, starting a Systematic Investment Plan (SIP) in an equity or balanced fund would be a better investment idea in the long run.
It is better to invest in funds whose portfolio constitutes of highly-rated bonds. For example, a liquid fund that invests in AAA-rated bonds. AAA is the highest rating and such bonds are the safest. It is also important to keep track of downgrade in bond rating to avoid losses if the issuer company defaults on its debts. There is no point in going for riskier bonds because the reason you invest in liquid funds is for the safety of principal and certainty of returns.
(The author is CEO, BankBazaar.com)