Liquid funds are well known as good instruments for short-term investments. But do you know where they invest and how to pick the right ones? We discuss all this in this post.
So…
What are liquid funds?
Liquid funds are debt funds that can only invest in securities with a residual maturity of 91 days or less. The funds make investments mostly in treasury bills, corporate deposits, money market instruments, etc.
Generally, liquid funds are known to deliver higher returns than regular savings account or your short-term fixed deposits. The post-tax returns are even better if money is held for more than 3 years (will discuss in detail in the later part of this post).
Here is a look at the liquid fund category average annual returns:
What about risks?
They are not risk-free but in general, the risks are negligible in liquid funds. At least in those whose fund managers manage the portfolio without being too adventurous. But compared to all other debt fund categories, the risks are much lower but non-zero. Given the upper limit on the residual duration of portfolio constituents, these are less sensitive to interest rate fluctuations.
Some of the liquid funds also offer instant redemption facility (up to a maximum of Rs 50,000 or 90% of the investment value, whichever is lower). Redemptions otherwise also are usually processed in a day.
One of the problems with the current definitions for SEBI categories is that for Liquid funds, it only defines the cap on residual maturity of portfolio components. But there is no restriction on the credit quality. So it’s possible that given that fund managers cannot take too much interest risk (due to 91-day cap on maturity), they might be tempted to take some credit risk to enhance returns. This can work in good years but may not all the time (as has been seen some time back when NAVs of few badly managed liquid funds fell sharply in one day).
So…
How to pick good liquid funds?
Here are a few basic pointers to guide you:
- Stick with funds that have reasonably long track records.
- Stick with funds that have a quality portfolio.
- Stick with funds houses of good pedigree.
- Stick with funds that have a large AUM.
- Avoid funds that have too concentrated a portfolio.
- If the above conditions are met, then picking funds having lower expense ratio is better.
- Do not try to change funds every year basis one-year performance. In fact top performer in liquid fund may change weekly or monthly. You need to look at the portfolio composition to see what is causing this outperformance.
These are just a few of the basic pointers for you to pick the right liquid funds.
Also note that now there is a graded exit load on liquid funds if redeemed before 7 days. This is what has made overnight funds (which have no exit loads) a good option for those who want to just park money for less than 7 days. Mostly institutional investors. Do read overnight funds vs liquid funds for a detailed comparison.
Coming back to the point about how liquid funds are alternative of savings account and short-term fixed deposits.
Liquid funds can be part of one’s Emergency Fund. Let’s say you plan to hold 6-12 months’ worth of expenses in your emergency reserves. So out of this, 1-3 month’s worth can be parked in a savings account while the rest can be in liquid funds or a combination of bank FDs and liquid funds.
So liquid funds are good alternatives for investors who would otherwise consider a savings account or a fixed deposit.
How are liquid funds taxed?
The returns from liquid funds are considered as capital gains. These are not taxed like fixed deposit taxation on accrual but are taxed only when realized at the time of sale. The rate of tax depends upon whether the capital gains are earned over a short or a long-term period.
- Short Term Capital Gains (STCG) – If gains are made in liquid funds held for less than 3 years (or 36 months), then it is taxed as per the investor’s income tax slab rate.
- Long Term Capital Gains (LTCG) – If gains are made in liquid funds held for more than 3 years (or 36 months), then it is taxed at 20% with indexation
Do read how indexation reduces tax on debt fund capital gains. Also consider going through how debt funds are taxed?
So that was about liquid funds.
If you are looking to park some idle money for a short period, typically for a few months than liquid funds can be a good option. Many investors also use it to park a part of their emergency fund. It can also be used to park a lumpsum amount and then run an STP into equity funds.
Liquid funds are a good alternative to savings accounts and short term bank deposits as they offer better average returns and decent liquidity.