Introduction

If there is a golden rule that all renowned investors follow, it is not to put all your eggs in one basket. For investors, diversification is essential to safeguard their interests. A portfolio with investments in carefully selected investment instruments protects you from risks and optimizes the returns.

In today's time, the sheer number of investment options can confuse or overwhelm any investor. Thus, it becomes vital to understand these options to assess if they fit into your investment strategy.

One such option is that of a liquid fund . Let us explore these funds in detail and comprehend their features and different aspects.
 

What are Liquid Funds?

A liquid fund is a mutual fund instrument that invests in debt and money market securities. These securities include treasury bills, commercial papers, certificates of deposits, bank term deposits, etc.

The important part to note here is that these funds have a tenure of only 91 days. There is no lock-in period, and you can withdraw your money anytime.
 

What are the Features of Liquid Funds?

Here are the key features of liquid mutual funds that can help you make an informed investment decision.

  • A liquid fund allows you to invest your money for a short period. It is better than letting your money sit idle in your bank account. This is why several business owners prefer this instrument to park the money they do not need at the current moment.
  • With a liquid fund , you can withdraw your money even the next day of your investment. In this case, you will earn the accruals earned for that one day when you were invested. It almost works like your funds in your bank account, and hence the name, liquid funds. 
  • Your money will get credited into your account the next day of submitting your withdrawal request.
  • Most companies do not include any exit load if you pull out after a week. You do not have to pay any penalty or processing fee for early withdrawal. As a result, your cost of investment gets reduced. 
  • There are no assured returns on liquid funds. Its performance depends upon the market.
  • Liquid mutual funds do not experience too many fluctuations. Moreover, the maturity of the selected securities matches the maturity of the fund to deliver high returns. 
  • Liquid mutual funds are considered to be less risky. As they invest in debt instruments, the risk is lesser than in equity mutual funds. However, the risk is higher compared to fixed deposits. It is ideal for investors who can take on some degree of risk and can wait to stay invested throughout the maturity period for the best returns.
  • TDS does not apply to liquid mutual funds . It is unlike other mutual funds where tax gets deducted at the source. This feature makes a liquid fund appealing to several investors.
     

Who Should Invest in Liquid Funds?

Liquid funds are ideal in a few circumstances. Suppose you have received a large bonus or a substantial payment from a vendor. You want to invest it systematically or want to research your options before making a financial commitment. In this situation, while you are weighing your alternatives, you can invest in liquid mutual funds .

As you can invest for even a short period, you can park your money in this instrument until you decide where you want to invest your money. 

Another scenario where you can consider a liquid fund is when you want to develop a Systematic Withdrawal Plan to create an alternate income stream. It allows you to get a monthly payment like a pension to manage your household expenses.

How Do Liquid Funds Work?

A key feature of liquid mutual funds is to ensure the safety and security of investors' funds. To provide this, fund managers select high-rated debt instruments that mature in 91 days. 

A liquid fund can allocate your money to different debt instruments. The proportion of these funds will depend upon the objective of the liquid fund. Thus, it is essential to research your options before making a decision.

When you invest in a liquid fund , it is crucial to understand the net asset value of the debt. If you invest before 2 pm on a trading day, the fund gets processed as the previous day's NAV. The catch here is that you need to submit your application at your AMC office and transfer the funds before 2 pm. 

When you invest in liquid funds, your income comes from the interest rate on the debt holdings of the fund. Interest rates and bond prices follow an inversely proportional relationship. When the interest rates fall, bond prices increase, and when the interest rates go up, the bond prices reduce. It is the reason liquid mutual funds are prone to interest rate risk.

The market value of the securities does not change much when the interest rates change. Due to this, there are minimal chances of incurring considerable capital gains or losses.

What is the Tax Liability in Liquid Funds?

Your earnings from liquid funds are considered capital gains, and they are taxable. However, the rate of taxation is not fixed and depends entirely on how long you want to hold your investments. 

The gains made in the first three years are called short-term capital gains. In this case, the income you make gets added to your annual income. The tax rate is as per your income slab. Similarly, if you receive any dividends, that income also gets added to your overall income.

On the other hand, if you stay invested for more than three years, your gains are considered long-term capital gains. This income gets taxed at a flat rate of 20% after indexation. 
 

What Factors Should You Consider Before Investing in Liquid Funds?

As an investor, here are the factors you may want to consider before investing in liquid mutual funds .

Risk

Although the risk associated with liquid mutual funds is marginal, they are not entirely risk-free. The NAV of the underlying assets doesn't fluctuate frequently and largely keeps you protected during the 91-day maturity period. However, if the underlying assets get downgraded drastically, the NAV gets reduced too. 

Time Horizon

These funds are ideal if you have a short investment horizon of up to three months. It is a relatively safe space to park your funds. However, if you have a longer investment horizon of a year, you can look at other options like ultra-short mutual funds.

Emergency Fund

Financial emergencies can arise in anyone's life and at any time. Liquid funds are a good place to keep your emergency fund as you can withdraw your funds anytime. Moreover, you can earn interest on your investment.

Cost

Like all other investment options, you will have to bear a small expense for investing in a liquid fund. As per SEBI guidelines, this amount, called the expense ratio, is capped at 1.05%. 

Returns

Although the returns on liquid funds are not assured, they have given returns in the range of 7-9% historically. It is significantly higher than the current bank rates on savings accounts. It is the reason you may want to consider these funds over parking your money in your bank account.
 

How Should You Select a Liquid Fund?

When you go into the market, you will come across several such funds offered by different AMCs. To make a decision, you can assess the following characteristics.

  • Look at the past performance of the liquid fund to understand the portfolio quality.
  • Check the expense ratio of these funds.
  • It is always good to check the portfolio to understand the credit quality. 
     

Final Words

Liquid mutual funds are an excellent investment choice for individuals with surplus funds looking for a short-term investment option. It is also ideal for businesses interested in a convenient way for cash management.

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