Liquid funds are ideal for low-risk investors looking to park surplus cash for the short term. The biggest advantage of liquid funds is that it offers superior returns than bank deposits.
But the returns on liquid funds is not guaranteed. This is the biggest disadvantage of liquid funds.
So, should you invest in liquid funds or not? Well let us answer this question by understanding the 16 most important advantages and disadvantages of liquid funds.
13 Most Important Advantages of Liquid Funds
Superior Returns: Mutual funds have a track record of generating higher returns than bank deposits. In the last 10 years bank deposit rates have fallen sharply. But the return on liquid funds have been a steady 7%-7.5%.
Tax Benefit: Liquid funds follow debt taxation. Their holding period is 3 years. When you redeem after 3 years, you get the benefit of indexation. Indexation increases your purchase price. When your purchase price increases, your profits decrease. This helps you lower your tax payable.
Low-Risk: Liquid mutual funds invest in papers which mature in less than 91 days. These papers are AAA rated and carry very little default risk. They are generally issued by strong private or public companies and the government. Hence, liquid funds carry very little risk.
Retail Participation in Fixed Income Market: Liquid funds provide retail investors a chance to participate in the Indian fixed income market.
This market was earlier dominated by banks, insurance companies, pension funds etc. It was not possible for common investors to participate in fixed income market. But liquid funds, by pooling money from lakhs of investors, has made it possible for retail investors to participate in the fixed income market.
High Liquidity: Liquidity refers to how quickly an asset can be converted into cash. Liquid funds are highly liquid. The redemption from liquid funds is processed in T+1 day. T stands for transaction day. So, if you redeem on Friday, then the redemption amount will be credited on Saturday. You can redeem from liquid funds within 1 day also. There is no lock-in period.
Low Exit Loads: Debt funds are popular among investors but they come with high exit loads. Credit risk debt funds have an exit load period of 540 days. In comparison, liquid mutual funds have exit loads of less than 7 days. So, you can redeem from liquid funds without any penalties within just 7 days!
Low Interest Rate Risk: Since liquid fund papers mature within 91 days, they are not heavily impacted by interest rate fluctuations. The Net Asset Value (NAV) of liquid funds fluctuates very less compared to equity funds.
Real time price discovery: The market price of equity funds is not available on Saturdays and Sundays. But the NAV of liquid funds is also available for Saturdays and Sundays. Liquid mutual funds are the only type of mutual funds whose NAV is calculated for full 365 days.
Perfect for Systematic Transfer Plan (STP): Liquid funds are also perfect for doing STP into equity Funds. Lumpsum investment in equity funds is not recommended as it involves timing the market. To avoid lumpsum investing, STP is preferred by retail investors. In an STP, a fixed amount is shifted from liquid fund to equity fund. In this way, you achieve cost-averaging. You also earn higher returns on the liquid fund balance.
Low Expense Ratios: Liquid funds are professionally managed. To manage the portfolio, fund houses charge a management fees which is a part of the fund’s expense ratio. Expense ratio and portfolio returns are inversely related. Liquid funds carry very low expense ratios. Hence, they offer higher returns.
Minimum Investment: Liquid funds are better than Bank FDs as they are affordable. In a Bank FD, you need to invest a minimum of Rs 5,000. But in liquid funds, you can invest with as little as Rs 500 via SIPs. Even lumpsum investing starts at Rs 1,000 only. Hence liquid funds are easy on the pocket.
Flexibility: Liquid funds come with both growth and dividend option. Investors looking for capital appreciation can opt for growth option. Investors looking for regular income can opt for dividend option. But dividends are now taxable in the hands of investors. So, investors in the highest tax bracket end up paying more tax in dividend option.
Great for Senior Citizens: Senior citizens or retirees typically invest in Post office savings scheme, Senior Citizens saving Scheme (SCSS) etc. But these investments come with long lock-in periods. They also have premature withdrawal penalty.
Hence, in case of emergencies, these investments cannot be redeemed without penalty. This does not happen in liquid funds. Liquid funds only have a 7-day lock-in period. Post 7 days, you can freely withdraw from liquid funds.
Most Important Disadvantages of Liquid Funds
No Guarantee: liquid funds are also linked to the market. Hence, they experience constant fluctuations. There is no guarantee of safety of principal in a liquid fund.
For example: Suppose you invested Rs 5 lakhs in a Bank FD. On maturity the bank guarantees to repay you Rs 5 Lakhs. So, you do not lose your invested capital.
This guarantee is not available in liquid funds. Since liquid funds are marked linked, there is a chance of the capital getting eroded. But since liquid mutual funds invest in AAA rated papers, they are very safe.
But since liquid mutual funds invest in AAA rated papers, they are very safe.
Taxation: Short term capital gains in liquid mutual funds are added to your income and taxed as per your tax slab. So, investors falling in the highest tax bracket end up paying higher short term capital gains tax.
Management Fees: When you invest in bank deposits, you do not have any pay any fund management fees. This is because the bank only holds your money. It does not manage your money. But in a liquid fund, your fund manager manages your portfolio and charges a fund management fees.
Compared to 2%-2.5% expense ratio of equity funds, the expense ratio of liquid funds is very low. For example: The expense ratio for TATA Liquid Fund – Regular – Growth is only 0.33%.
As you can see, the advantages of liquid funds far outweigh the disadvantages. Hence liquid funds are the perfect investment option for retail investors.
Investors looking to park surplus short-term cash or bonus can consider investing in liquid funds.
But just because liquid funds carry less risk, does not mean that all liquid funds are great for investment. RankMF has discovered the 5 best liquid funds in India. These funds have consistently beaten the market and are top performers. Find out and start investing in the best liquid funds in India by opening a FREE RankMF account.
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