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Liquid Mutual Fund – What, Why & How

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When you have the option to invest in equity stocks for long-term growth and enjoy steady growth of debt market, why not something for the liquidity of money market as well? Liquid mutual funds fill this gap. They provide a perfect alternative for a savings account, except with better tax-saving and safety from the urge to spend.

What are Liquid Mutual Funds?

A liquid mutual fund is a debt fund that invests in ultra-short-term fixed-income and money market instruments like treasury bills (T-bills), commercial paper and Repos. Majority of these instruments have a maturity less than 91 days while almost all of the instruments will mature within 365 days.

Overnight Liquid Funds

Overnight funds are another form of liquid funds where the primary investment is focused on a single day (overnight) maturity of the instruments. These funds will invest in securities like CBLOs, overnight reverse Repos, and other debt securities maturing in a single day.

Unlike closed debt and equity funds liquid funds do not have a lock-in period and you can enter/exit the scheme whenever you desire. Liquid mutual funds are portrayed as an alternative to the savings account.

Liquid means fluid, and in terms of investment, it means easily convertible into cash. As the name goes, you can receive your money in your account from a liquid fund within one working day of withdrawal.

Liquid Fund vs. Other Debt Funds

Liquid fund is a subset of debt funds and yet it differs from a debt fund in the following aspects:

  1. Zero Exit Load

The purpose of liquid mutual funds is to provide you with a safe option to temporarily park your funds. Thus, you should have the freedom to withdraw funds anytime you want without incurring penalties. Unlike other fixed-income deposits and mutual funds, liquid funds do not levy exit load, whether you withdraw within a few days or few months.

As per the latest guidelines given by SEBI, liquid funds can have an exit load on withdrawals happening within seven days of investment. However, this rule does not apply on overnight funds. So, you can use these funds if you need to park large sums for less than a week.

2. Liquidity

Liquid funds offer fast and easy redemption facility. The ease of redemption varies from one fund to another. Few of the funds also offer instant redemption on liquid funds – you can get cash from liquidation within 30 minutes into your account. The other debt funds are not as liquid as ‘liquid funds’. The redemption amount can take up to two working days to come to your account after placing a request.

3. Investment Risk

Liquid funds carry the lowest investment risk among all types of mutual funds. Two factors which contribute to the safe profile of liquid funds are – short-term nature of debt securities, and the tight financial requirements of issuers.

Benefits of Investing in Liquid Funds

Liquid funds offer you a number of unique benefits. The qualities of liquid funds enable you to use these funds for very specific purposes, such as:

Capital or Corpus Preservation

Often you may have a windfall income, or accumulated corpus for a financial goal. However, if you need time to decide where to invest your windfall income or still have a few weeks to go before you fulfil the goal, you can park your funds here.

Liquid funds with their safety and market linked returns will keep your funds not only safe but also provide a little bit of growth as well.

Systematically Invest in Other Funds

Liquid funds are the best option if you want to SIP (systematic investment plan) into more aggressive funds but you can only invest lump sum money. Instead of directly investing in the equity growth fund, you can park the lump sum money in a liquid fund and opt for a systematic transfer plan (STP).

STP allows you to create rupee cost averaging while investing in equity funds even with a lump sum investment.

Withdraw Tax-Free Pension

If you are considering saving for your retirement using unit linked plans (ULIPs), you can have a tax-free pension after retirement. However, unlike your budget needs, ULIPs offer annual withdrawals to remain tax-free.

Liquid mutual funds are the perfect solution for you to park this lump sum and use systematic withdrawal (SWP) feature to receive a monthly pension. There will be tax, however. But, only on the gains of the liquid fund which will be nominal (unless your annual withdrawal is about Rs. 50 lakhs or more).

How Does Liquid Mutual Fund Work?

Like any other mutual fund, a liquid fund collects money from several investors. However, the fund has to follow strict investment guidelines provided by SEBI:

  • Liquid funds can only invest in listed commercial papers
  • Not invest more than 20% of the total portfolio in securities from a single sector
  • Invest minimum 20% of the portfolio in government securities (gilts), T-bills, and Repo on gilts
  • Both types of liquid funds to not invest in securities with structured obligations or credit enhancement ratings

Liquid funds come with two investment options same as any other mutual fund:

  • Dividend Option

In this option, profits made by the scheme are distributed among the investors by ways of dividends on a quarterly, half-yearly or yearly basis.

  • Growth Option

In this option, the profit made by the scheme is not paid as dividends instead gets accumulated and forms part of the scheme via reinvestment.

You can understand the two with the below example.

DateActionFund ABC with Growth OptionFund ABC with Dividend Option
Jan 2010New Investment at NAVRs. 100Rs. 100
Oct 2010Fund NAVRs. 109Rs. 109
Oct 2010Dividend paid (per unit)NilRs. 2
Oct 2010NAV after DividendRs. 109Rs. 107
Oct 2011Complete Withdrawal at Fund NAV (Scenario 1)Rs. 109Rs. 107
Oct 2011 Short-term capital gain in FY 2011-12 Rs. 9Rs. 7
Oct 2011Taxable Dividend in FY 2011-12NilRs. 2
Dec 2015Complete Withdrawal at NAV (Scenario 2)Rs. 157Rs. 115*
Dec 2015Long-term Capital GainRs. 57Rs. 15

How to Evaluate Liquid Funds?

There are close to a hundred liquid funds available in the market. Which one should you pick? You can use the below parameters to evaluate liquid funds:

  • Larger AUM (Asset Under Management)

As a rule of thumb, you should invest in a liquid fund which has an AUM of at least Rs. 20,000 crores. Liquid funds invest in securities that have a fixed maturity. If many investors, all at once, redeem from the liquid fund, the fund house will have to prematurely withdraw from securities and it will adversely impact returns for all investors.

The fund managers have cash ready for scenarios like these but if pressure is too much, it can cause issues. For the same reason, you should always choose liquid funds that are large.

  • Total Expense Ratio (TER)

The expense ratio shows how much of your investment is used by fund houses to manage the expense. Lower the expense ratio, higher the returns for you and vice versa.

How to Check TER for Liquid & Overnight Funds?

Indian mutual fund houses are expected to regularly report their TER to the regulator SEBI and AMFI (Association of Mutual Funds in India). Thus, if you want to find the latest expense ratio of any scheme you can simply visit the AMFI website (https://www.amfiindia.com/) and click on the link for ‘TER of MF Schemes’.

You will need to select the year and month for which you want to check the TER. The website can give you TER for all the schemes once you specify the scheme type you are looking for.

Should You Invest in Liquid Funds?

Before you make any investment, it is very important you ask yourself – ‘What is the goal I want to achieve from my investment?’ Once you know the answer to this question, you can decide where you should invest to achieve your goal. For example, if your goal is high returns, you should be investing in Equity funds.

If you have a good amount of cash-in-hand or money sitting in your savings accounts and have no plans of using it in the near future, then you should consider investing in liquid funds. You can earn better returns with liquid funds compared to returns from savings account interest.

If you have less risk appetite, you should invest in liquid funds. You can generate a return of around 7-9% given that you are investing in the high rated (AAA or AA) liquid funds. You can also park your emergency funds in liquid funds because they are as good as money in the savings bank account.

Another scenario where you can think of investing in a liquid mutual fund is – ‘annual fees of your child’ which is a heavy-duty task or other similar scenario where you want to park money for a certain time period (short term) and you also want to keep your investment safe.

If you have to pay your child’s annual school fees every April, it won’t be easy to pay this amount altogether so you may start a SIP in March of the same year and invest a small amount every month in liquid funds.

Are Liquid Mutual Funds Safe?

A liquid mutual fund is placed at the lower end of the risk-return spectrum. Liquid funds are not entirely risk-free but they are low risk-low return instruments.

As they invest predominantly in debt instruments, they are subject to interest rate risk and credit risk. A change in the prevailing interest rates may cause a difference in the price of the debt instruments.

Liquid funds have substantial exposure to papers in the finance and banking sectors. This risks the safety of your liquid fund. A slowdown in economic activity and RBI’s loan moratorium can bring challenges for many firms.

If the non-performing assets of these firm pile-up, it will have an impact on the mutual funds holding exposure to such firms and you will bear the brunt.

How Are Liquid Fund Returns Taxed?

The tax on your investment depends on the holding period of your invested capital and the type of your investment plan – growth or the dividend. So, your liquid fund investments will face the following three tax scenarios:

  1. Short-Term Capital Gain

If you choose to invest in the growth plan and if you redeem your investment before 3 years (36 months) then you have to pay Short Term Capital Gain (STCG) tax which will be taxed at slab rates

2. Long-Term Capital Gain

If you redeem after 3 years then you have to pay long-term capital gain tax which includes indexation benefits and is taxed at the rate of 20 per cent.

3. Dividend Distribution Tax

If you invest in the dividend plans then all dividend funds have a dividend distribution tax. The dividends declared are not taxable to you but what you receive is the amount after-tax deduction.

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