Liquid Mutual Funds: Basics, Advantages, Taxes & More | Nivesh

What are Liquid Mutual Funds and why should you invest in them? Read on to know how to invest in Liquid Mutual Funds, their tax benefits, redemption protocols, and more.

What is a Liquid Mutual Fund

These are a type of Mutual Fund that invests in securities with a residual maturity of up to 91 days. The portfolio of Liquid Mutual Funds comprises primarily short-term fixed assets generating money market instruments such as commercial paper, government securities, treasury bills, etc. The Net Asset Value (NAV) of these funds is calculated for 365 days and redemptions from the funds can be processed within 24 hours.

While on one hand, they do not involve tying up the investors’ assets for a long time as they do not have a lock-in period. Usually, investors looking for better returns prefer to put their money in Liquid Mutual Funds rather than in Fixed Deposits, especially when market sentiment is favorable. Additionally, Liquid Mutual Funds do not impose an exit load in case of premature redemption.

How do Liquid Mutual Funds Work

The core positioning of Liquid Mutual Funds in the platter of investment options is derived from their unique offer of a high degree of liquidity along with the safety of the investors’ capital – a combination of two vital traits that are usually in a trade-off juxtaposition in case of most financial instruments. 

The fund manager, thus, invests in a range of high-rate debt instruments with a maturity of up to 91 days. Since the maturity of the underlying securities in the fund’s portfolio corresponds quite well with the maturity of the fund, it insulates the value of the Liquid Mutual Fund quite effectively against too much fluctuation in the prices of the underlying securities.

The short-term maturity of the fund also mitigates the sensitivity of the returns to interest rate fluctuations and helps to deliver higher returns than most investment instruments in the market. Further, Liquid Mutual Funds do not have a lock-in period however they do possess an exit load if the funds are redeemed within 7 days.

In other words, Liquid Mutual Funds combine low risk with liquidity comparable to that of a savings bank account, but with a higher return on your money than a savings account. All these features make Liquid Mutual Funds a robust and attractive investment option for your spare cash.

Advantages of Liquid Mutual Funds

Investing your idle funds in Liquid Mutual Funds for short-term gains comes with a number of advantages.

• Low cost: Since Liquid Mutual Funds are short term funds, they do not need to be as actively managed as some of the other debt funds. As a result, these are low-cost debt funds. As per SEBI guidelines, most liquid funds operate with expense ratios below 1%, and such a low cost structure enables them to maximize the effective returns to the investor.

• Low Risk: Unlike funds with longer maturity periods, the primary focus of Liquid Mutual Funds is to provide an avenue for safe investment with steady returns at a low risk. This is accomplished by creating portfolios of high quality debt instruments that remain fairly stable across different interest rate cycles in the market. 

• Quick Redemption: In case of Liquid Mutual Funds, the high liquidity of the funds is due to the extremely quick redemption process. Redemption requests are typically processed within one working day, and some funds even offer the facility of instant redemption. The brief redemption period is made possible by the highly liquid nature of the securities with low probability of default.

• Flexible holding period: The holding period for Liquid Mutual Funds is highly flexible, and investors can hold their investment for as long or as little time as they wish, beyond the first seven days. Only if the investor wishes to pull out in the first seven days, is a small exit load charged. Such flexibility in the holding period makes it easy for the investors to enter and exit the funds, and at the same time, earn safe, market‐linked returns for the time period of their investment.

Who Should Invest in Liquid Funds

Investing in Liquid Mutual Funds is ideally suited to certain investor profiles because of certain characteristics of these funds:

• High Liquidity for Large Idle Amounts: Liquid Mutual Funds are principally meant for investors with high liquidity requirements as well as large amounts of idle cash, for which they need a short-term investment avenue. Instead of putting their spare cash in savings accounts, they can choose to invest it in Liquid Funds, thus increasing the returns on their money. Thus, these funds are suitable for:

1. Investors with a short investment horizon
2. Investors who invest in bank deposits
3. Investors who need to maintain emergency funds
4. Investors who wish to route their funds into Equity Funds

• Good Return on Windfalls: Another category of investor who might find Liquid Mutual Funds attractive is one who has a windfall, such as performance incentives, gains from sale of capital assets or a bonus, which they want to park somewhere for a short duration, without tying it up for a long period, and at the same time, earn an attractive return on it. In this sense, these funds are suitable for Investors who wish to park funds temporarily.

• STP Avenue: Some investors may also invest in Liquid Mutual Funds as an avenue for investing in Equity Funds. Such investors initially invest in a Liquid Fund, from where they do a Systematic Transfer to an Equity Fund of their choice over a specified time period.

Things to Consider Before Investing in Liquid Funds

Before venturing into Liquid Mutual Fund investment, investors need to get a few facts clear, so that they can make informed choices about the destination of their investments.

• Objective of the Investment: Liquid Mutual Funds are a great option as an avenue for investing your emergency funds. Since they combine the advantages of a good rate of return with high liquidity, they allow you to grow your money and still have it readily accessible in case you need it urgently. 

• Duration of Investment: The ideal investment period or investment horizon for Liquid Mutual Funds is around three months. Since the component securities of the liquid funds’ portfolios usually have a maturity of around this period to coincide with the 91-day maturity of the funds, an investment horizon of around three months in liquid funds allows the investors to realize the full potential of these securities. 

• Cost: The cost of holding a Mutual Fund is its expense ratio. The expense ratio is a small fee that Mutual Funds charge to professionally manage your investment. The Expense Ratio is usually maintained at a reasonably low level in view of the ‘hold till maturity’ strategy of the fund managers.

• Risk Factor: Even though no investment can be completely risk free, Liquid Mutual Funds are amongst the lowest-risk investment avenues in Mutual Funds, chiefly because of their short maturity period. The risk associated with Mutual Funds is a function of fluctuations in their Net Asset Value (NAV), but since the assets underlying Liquid Mutual Funds mature within two to 3 months, fluctuations in their prices are not able to significantly impact the NAV of the funds, thus insulating the returns from risk to a large extent. A possibility of risk to returns on Liquid Mutual Funds, however, exists if there is a sudden drop in the credit rating of the underlying securities.

• Returns: Liquid Mutual Funds generate between 3% and 5% rate of return. Even though there are no guarantees, empirical evidence suggests that Liquid Mutual Funds invariably deliver on their promise.

Liquid Mutual Funds Taxation

The dividends offered by all Mutual Funds become part of your taxable income and are taxed as per your income tax slab.

As far as Liquid Mutual Funds are concerned, just like all debt-based funds, Liquid Mutual Funds, too, generate capital gains upon redemption, and these capital gains are taxable. Your rate of taxation is determined by your tax slab and the period for which you stay invested in the fund, also known as your Holding Period. 

The capital gains that are earned in the first three years of holding a fund are known as Short Term Capital Gains, while those after three years of holding are Long Term Capital Gains. Short Term Capital Gains earned from Liquid Mutual Funds are added to your income for taxation purposes and taxed according to your income tax slab. 

Long Term Capital Gains, however, are taxable at a flat rate of 20% after indexation. 

Frequently Asked Questions (FAQs)

1. How to Invest in Liquid Mutual Funds Online?

Any investor can enjoy the benefits of investing through Nivesh in the following easy steps:

• Create an account in Nivesh by providing your basic KYC details. (If you already have an account then just login into your account)
• On your portfolio page click on the Buy New tab at the right top corner of the screen.
• Select the category and choose the funds you want to purchase.
• If you already know the name of the fund to buy, then you can search the particular fund through Quick Order.
• Fill the transaction details and confirm. You can place up to 5 orders in one go.
• You can make payment through your registered account through UPI, Direct Pay, or NEFT/ RTGS , Bank Mandate or Cheque. For same-day NAV, select UPI, Direct Pay or NEFT / RTGS as other payment options may take a few days to clear, Nodal account takes about 1-2 days to clear payment from the approved mandate and cheque takes about 2-5 days in clearing due to which you will not get the same-day NAV.

2. Is Liquid Fund Better Than FD?

Investors who wish to earn a better return on their money than savings accounts and bank fixed deposits in the short term can invest in Liquid Mutual Funds. 

• Risk: Of the two, while fixed deposits are extremely low-risk, since they are offered by banks or non-bank financial intermediaries (NBFCs), and usually have an insurance policy protecting the invested capital and interest up to Rs. 1 Lakh per bank, Liquid Funds are affected by market volatility, and in this respect, are a little higher-risk investments than FDs. However, Liquid Mutual Funds have a definite advantage over Fixed Deposits in terms of:

• Returns: Liquid Funds offer better returns than FDs. FDs offer a fixed rate of return that is governed by the RBI and is higher than the return on savings accounts. However, although Liquid Mutual Funds do not offer guaranteed returns, they usually yield higher returns than FDs. As long as the investors read the offer document carefully before investing and ensure that the fund manager does not intend to take high risks while managing the portfolio, the earnings are better on Liquid Funds.

• Liquidity: Liquid Funds have a highly flexible holding period, and after the initial seven days of holding, do not levy an exit load upon early redemption. FDs, on the other hand, levy around 1% of applicable interest and penalty for early withdrawal. In case of Liquid funds, however, the exit load, even in the first seven days of holding, is a graded one, starting at 0.007% on the first day, and going down to 0.0045% on the seventh day.

3. Do Liquid Funds Have a Lock-in Period?

No, Liquid Funds do not have a lock-in period. They have a completely flexible holding period and can be redeemed at any point in time. Further, the liquid fund redemption time requests of such funds are processed within a single working day.

4. Do Liquid Funds Have an Exit Load?

A year ago, however, SEBI imposed a very small Exit Load with a graded structure, only for redemption within the first seven days of holding, which starts at 0.007% on the first day, and goes down to 0.0045% on the seventh day.

5. How Do I Choose a Good Liquid Fund?

While looking to invest in Liquid Funds, the criteria for selection do not return, since most Liquid Funds yield comparable returns, in the range of 3-5%. The valid criteria to choose between various Liquid Funds are based on the safety of capital and good fund management.

• Large AUM: For Liquid Funds, a large capital base or AUM (Assets under Management) is an important criterion. Since Liquid Funds invest in securities that have a fixed maturity (up to 90 days, if many investors redeem prematurely, the fund manager will, in turn, have to prematurely withdraw from securities, thus adversely impacting returns for all investors! Therefore, it is advisable to choose Liquid Funds with large AUM as they would be able to handle redemption pressures better than Liquid Funds with smaller AUMs.

• AAA Credit Quality of Underlying Securities (as a percentage of total AUM): The investors’ capital is safest if it is invested in the most credit-worthy securities.

• Low Expense Ratio: While Expense Ratio, which is a sort of service charge levied by fund managers, is hardly a consideration in Equity Funds, in case of Liquid Funds, the work of fund managers is minimal. Further, the returns of most Liquid Funds are comparable, and thus, even slight variations in Expense Ratio can translate into larger variations in total.