In this article we cover
1) What is Liquid Fund?
2) How do Liquid Mutual Funds Work?
3) What are the Advantages of Liquid Mutual Funds?
4) Are Liquid Mutual Funds Safe?
5) Who Should Invest in Liquid Mutual Funds?
6) How are Liquid Mutual Funds Taxed?
7) Things to Consider before Investing in Liquid Funds
8) How to Invest in Liquid Mutual Funds?
What is Liquid Fund? – Definition of Liquid Funds
Liquid mutual funds are a type of debt funds. Liquid mutual funds invest in instruments which mature within 91 days. Liquid mutual funds invest in ‘debt’ instruments issued by public or private companies and the government.
Liquid mutual funds invest in:
- Commercial Papers (CP)
- Certificates of Deposits (CDs)
- Treasury Bills
Since the maximum maturity of papers is only 91 days, liquid funds are less volatile to interest rate movements.
How do Liquid Mutual Funds Work?
Suppose your friend Jay asks you to give him Rs 1 Lakh for 30 days. He promises to pay you Rs 100 as interest. Jay is trustworthy and you decide to loan him Rs 1 Lakh.
After 30 days, Jay returns Rs 1 Lakh along with Rs 100 as interest. The transaction is complete.
This is exactly what happens in liquid funds. Liquid funds give ‘very short-term’ loans to companies and the government.
- When corporates borrow funds for less than 91 days, they issue Commercial Papers.
- When the government borrows funds for less than 91 days, they issue treasury bills.
What are the Advantages of Liquid Mutual Funds?
Real Time Price Discovery: The Net Asset Value (NAV) of equity, hybrid and debt mutual funds is calculated only on working days. But the NAV of liquid mutual funds is also published on Saturdays and Sundays. This helps you discover the real-time value of your investments.
High Liquidity: Liquidity refers to how easily you can sell your investments. Prior to October 2020, liquid funds did not have any exit load. This meant that you could sell your units within 1 day.
But from October 2020, liquid funds charge an exit load on withdrawal before 7 days. Hence, if you plan to withdraw the funds before 7 days, then you should invest in overnight funds.
But even the 7-day exit load period is much shorter than debt funds, which have an exit load period of up to 540 days.
Faster Redemption: Liquid mutual funds have faster redemptions. They are redeemed in T+1 day. Here, T refers to the transaction day.
If you redeemed from your liquid fund on Monday, then the amount will be credited to your account Tuesday itself (T+1). This is much faster than equity fund’s T+2 days redemption rule.
Less Volatile to Interest Rates: Interest rates and bond prices have an inverse relationship.
- When interest rates rise = Bond Prices Decrease = Fall in Liquid fund NAV
- When interest rates fall = Bond Prices Increase = Rise in liquid fund NAV
- Low Cost: Liquid funds carry lower expense ratios than debt mutual funds. For example: The expense ratio for Aditya Birla Sun Life Liquid Fund – Regular – Growth is 0.32% only. A low expense ratio increases your portfolio returns.
Are Liquid Mutual Funds Safe?
Investors often believe that liquid funds are safe like bank fixed deposits. But this is not true. Liquid mutual funds also carry credit risk.
Credit risk is when the borrower fails to repay the principal amount or make timely interest payments. This usually happens when your liquid fund lends money to companies with poor credit rating.
Also, liquid funds are a type of mutual funds only. Hence there is no guarantee of capital protection. Unlike a Bank FD, your liquid funds also do not come with Insurance.
The best way to manage your liquid fund risks is by investing in liquid funds with 100% allocation to government, Semi-government or AAA rated papers.
Recently, SEBI has issued a new circular to reduce the risk of liquid funds. As per SEBI liquid mutual funds cannot invest more than 20% of its assets in just 1 sector. They can also not invest in risky assets to generate higher returns.
SEBI has also mandated liquid funds to hold 20% of its assets in cash to meet redemption pressures.
Who Should Invest in Liquid Mutual Funds?
Liquid mutual funds are perfect for parking short-term cash.
- Investors building emergency fund: In personal finance, investors must have 6-12 months’ worth of expenses kept aside in an emergency fund. Liquid funds are perfect for building emergency fund. They are highly liquid and redeemable within a day!
- Investors with short-term horizon: Investors with investment horizon of up to 3 months should invest in liquid funds. Investors with less than 7 days investment horizon should invest in overnight funds instead as they carry no exit load.
- Business owners with surplus cash: Business owners with surplus day to day cash can also invest in liquid funds rather than bank FDs. Since these investors fall in highest tax bracket, investing in liquid fund helps in saving tax through indexation.
Investors who want to invest in Equity Funds: A Systematic Transfer Plan (STP) is a great way of investing in equity funds.
In a STP, a lumpsum amount is invested in a liquid fund. From there, small instalments are debited every month and transferred to equity funds.
This way, you earn the return of both equity fund and liquid fund.
Investors looking for higher returns: Liquid funds offer 1%-2% higher returns than bank FDs. Additionally, liquid funds carry no withdrawal penalties after 7 days.
In bank FDs you have to pay a penalty on premature withdrawal even if you redeem 1 day before maturity.
How are Liquid Mutual Funds Taxed?
Liquid Mutual funds invest in ‘debt’ instruments and hence follow debt taxation.
- If you sell your liquid fund units before 36 months (3 years) then the gain is added to your income and taxed as per your income tax slab.
- If you sell your liquid fund units after 36 months (3 years) then a long-term capital gains tax of 20% with indexation is applicable.
Things to Consider before Investing in Liquid Funds
Liquid Funds are NOT 100% SAFE: Liquid mutual funds are much safer than equity funds. But they are not 100% safe.
In a bank FD, when you invest Rs 1 Lakh at least you have the guarantee that you will get Rs 1 Lakh back. There is no such guarantee in liquid funds. You might get less than the capital invested.
- Liquid Funds are NOT for long-term wealth creation: Liquid funds are perfect for short-term financial goals. But they are not suitable for long term financial goals. Equity mutual funds are the best option for long-term financial goals.
- Liquid Funds HAVE CREDIT Risk: Liquid mutual funds also carry credit risk. As we saw in the recent Franklin Templeton debt fund crisis, debt mutual funds can also default on its papers. Hence you should invest in only those debt funds that carry 100% AAA rated papers.
- Liquid funds generate HIGHER returns than Bank FD: Liquid mutual funds generate much higher returns than bank deposits. Here is a year-on-year comparison between liquid fund returns and FD returns.
List of Best Liquid Funds in India for 2021
|Funds||MF Rating||1 year||3 Years||5 Years||Since Inception|
|Mirae Asset Cash Management Fund - Growth||3.88%||5.85%||6.25%||6.47%|
|Edelweiss Liquid Fund - Regular Plan Growth - Growth||3.83%||5.85%||6.18%||8.03%|
|Baroda Liquid Fund Plan A - Growth||3.81%||5.88%||6.38%||7.32%|
|Hdfc Liquid Fund - Growth||3.79%||5.76%||6.24%||7.05%|
|L&t Liquid Fund - Regular Growth||3.89%||5.86%||6.35%||7.40%|
|Lic Mf Liquid Fund-growth-growth||3.95%||5.85%||6.31%||7.13%|
|Idbi Liquid Fund Regular Plan - Growth||4.20%||6.02%||6.41%||7.65%|
|Mirae Asset Cash Management Fund - Monthly Dividend Reinvestment||3.71%||4.48%||4.69%||5.17%|
|Mirae Asset Cash Management Fund - Weekly Dividend Reinvestment||3.78%||4.52%||4.70%||5.16%|
|Edelweiss Liquid Fund - Regular Plan Annual Dividend - Reinvestment||3.82%||5.86%||6.18%||7.23%|
Note: *Returns as of date 23rd February 2021
How to Invest in Liquid Mutual Funds?
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- Login to your RankMF account
- Complete your E-KYC. It only takes 5 minutes.
- Select the best liquid mutual funds based on RankMF’s 20 million parameters
- Invest in the best liquid funds.