Mutual Fund-Liquid Funds
Most of the people in our country keep their money in a savings account. Although there is no special return on this money, but you can earn more profit by investing your money in liquid funds. Now, what is a liquid fund and how does it work? Let’s learn more about it.
What is ‘liquid’ about them?
Liquid funds are in the category of debt mutual funds, which collect money from several investors and invest this amount in bonds of reputed companies and government bonds. Liquid funds are those mutual funds that offer high liquidity. This means, the units of these funds can be sold immediately, and the invested amount can be redeemed quickly.
How do Liquid Funds Work?
To understand how liquid funds work, you need to know where they invest and how they generate returns.
Where do Liquid Funds Invest?
A liquid fund will typically hold securities that are short term, of good credit quality, and highly liquid. A recent set of guidelines issued by SEBI has helped to reinforce these fund features.
Liquid funds can invest only in listed commercial paper, and they have an overall exposure limit of 20% in a sector. They are not permitted to invest in risky assets as defined by SEBI norms. These norms aim to contain credit risk in the liquid fund portfolio.
Further, liquid funds must hold at least 20% of their assets in liquid products (cash and cash equivalents such as money market securities). This ensures that they can quickly meet any redemption demands.
Sources of Earnings
Liquid funds earn mainly through interest payments on their debt holdings; a very small part of their income is generated via capital gains. This is a defining feature of liquid funds, so let us understand it in some detail.
When interest rates fall, bond prices go up. When interest rates rise, bond prices fall. The negative relation between bond prices and interest rates is stronger for long term bonds. This means that the longer the maturity of a bond, the more it responds to changes in market yields.
Since a liquid fund invests only in short term securities, its market value does not respond much when interest rates change in the market. This means that liquid funds do not have significant capital gains or losses. In a rising interest rate environment, liquid funds often outperform other debt funds because (i) their interest earnings are going up (ii) their market values suffer only to a limited extent due to capital losses. In market jargon, we say that liquid funds have a very low-interest rate risk.
Where do the fund managers invest these funds?
These funds are invested in short-term debt instruments with maturities of less than one year. Investments are mostly in money market instruments, short-term corporate deposits and treasury. The maturity of instruments held is between 3 and 6 months.
What returns do they bring to your coffers?
The returns from liquid funds don’t vary much as they invest in similar underlying securities. However, when looking for a liquid fund, the past return should not be the only factor for consideration. Other factors like size of the fund, credit quality of underlying securities and track record of the fund house should also be kept in mind.
How are they different from other “liquid’ investment schemes?
ULTRA SHORT TERM FUNDS
Risks are lower in this type of fund due to higher liquidity.
|Risks are a notch higher as compared to liquid funds due to their short-term nature of investment.||
Liquid funds cannot be a full-fledged substitute for a savings bank account. Barring some funds, you cannot withdraw money instantly (like you do with an ATM).
|Returns are ‘decent’ as these are not linked to market forces.||These instruments may also be traded in the market. Hence, the NAV may swing in response to market movements, making returns ‘a little modest’ than returns of liquid funds.||These funds pay low interest rates (about 4 per cent mostly and 6-7 per cent in the case of one or two banks) in savings account.|
|Liquid funds do not suffer exit load.||A few ultra-short-term funds may levy exit load for exits made immediately after investment (time for exit may vary between funds).||Amount in savings account can be withdrawn at any time without any ceiling.|
|NAV of liquid funds is not volatile as the only change in their NAV is mostly as a result of the interest income that accrues. In other words, given their short-term maturities, these instruments are hardly traded in the market. They are held until maturity. Hence, their NAV only sees a change to the extent of interest income accrued, every day, including weekends.||The NAV of ultra-short-term funds may swing in response to market movements, making it a little more volatile.||In savings account, the income is steady as the rate of deposit has not been changed for a long time.|
Features of Liquid Fund
- Liquid fund is popular as it is the only fund which pays dividend on ‘daily’ basis in addition to weekly, fortnightly & monthly options. This suits businessmen/traders who suddenly find that they have a cash surplus (due to additional foreign exchange earnings as a result of FOREX fluctuation especially in export transactions and/or additional profits due to a ‘spiral’ in the cost of the product in the market) desire to ‘park’ their surplus funds by investing in a ‘safe’ fund for a short-term period. So, individual investors can choose the daily dividend plan, weekly dividend plan or monthly dividend plans according to investor preferences.
- This fund is easily encashable say, within a couple of days of short notice, which adds to its popularity.
- This fund also enjoys income tax benefits like any other mutual fund. Besides, the tax is deducted at the hands of the fund houses & NOT at the hands of individual investors.
- This fund is considered to be of ‘low/average risk’ because there is no lock-in period.
- This fund does not have any Entry/Exit load. So, individual investors need not weigh this option while choosing the ‘ideal’ fund.
Limitations of Liquid Fund
- This type of fund is not very popular among brokers & fund advisors because of the rate of brokerage/commission paid to them is lower than other investment products. Due to this, the first-time mutual fund investors, many a time, are not told about this product, thereby affecting the growth of this fund.
- Due to its modest rate of return(as compared to other MFs), this type of fund has very few takers in the investment market.
- Very few would be made aware of the fact that this mutual fund does not have the “Systematic Investment Plan’ (SIP) tag, as it is a liquid fund & does not insist on a minimum period of investment under SIP; so any investor can exit at any time & get ‘returns’ for the period of holding. This singularly could be a dampener for first-time investors.
- There is a perceptible hesitancy in the minds of the investing public in going all-out for these liquid funds because of the rider –minimum investment, which also acts a dampener while taking investment decisions. Some feel that the minimum investment could be further brought down to Rs.1000 to enable widening of the net to attract small & retail investors.
Who Should Invest in Liquid Funds?
- Investors with a short investment horizon: Liquid funds are best suited for those with an investment horizon of up to 3 months, as the funds invest in securities with comparable maturities. Investors with longer investment horizons‐say 6 months to a year‐ should invest in slightly longer duration funds (say ultra-short duration funds) so that they can earn higher returns.
- Investors who invest in bank deposits: Investors who keep their surplus funds in bank deposits can benefit from liquid funds on two fronts: greater withdrawal flexibility and better returns. In a traditional bank fixed deposit, funds are locked‐in for a fixed period; and an interest penalty is imposed on premature withdrawal. In contrast, liquid funds offer flexible holding periods with easy exit options. Money in bank savings accounts can be withdrawn at any time, but they offer around 3%‐4% interest only, which is lower than the 5% plus usually earned by a liquid fund.
- Investors who want to keep contingency funds: The purpose of liquid funds is to provide liquidity and safety while generating a low return. Hence investors can park an emergency or contingency corpus in a liquid fund, with the assurance that it will be safe and can be redeemed when necessary.
- Investors who need to park funds temporarily: Liquid funds are cash management products that are designed to keep funds safe while earning a small return. Hence, a large sum of money, say, from a bonus or sale of property or inheritance, can be temporarily parked in a liquid fund until the investor decides how to invest the corpus.
- Medium to route investments in equity funds: Investors can hold funds in a liquid fund and use an STP to route investments systematically into an equity fund. This enables them to invest in equity periodically, while at the same time, the corpus in the liquid fund earns stable returns.
Keep These Things in Mind Before Investing in Liquid Funds
Liquid funds are among the least risky debt funds and often viewed as substitutes for bank deposits. However, low risk does not mean zero risks! Investors should understand that liquid funds also carry a few risks.
First, like all mutual fund products, returns are not guaranteed. Bank deposits will always pay the promised interest amount on maturity, but the return from a liquid fund is variable because it depends on market interest rates. That is why investors should check the track record of a fund and opt for funds with consistently good performance.
Second, liquid funds are not immune to credit risk. During the IL&FS downgrade in 2018, it was discovered that some liquid funds had invested in lower-rated debt securities to boost their returns. When these securities defaulted on interest payments, their credit rating was downgraded, and the liquid funds lost market value. Investors can reduce credit risk by choosing liquid funds with the highest quality portfolios.
Third, liquid funds are not wealth-creating products; rather, they provide safety and liquidity for a modest return. Investors must ensure that their financial goals and return expectations are in tune with the features of liquid funds.
Finally, liquid funds must be evaluated based on returns as well as expense ratios. Liquid funds are mainly generic products, so most liquid funds earn similar returns at any given time. Therefore, a fund with a high expense ratio will end up with significantly lower returns. For example, consider two liquid funds with yields of 6% and 6.5% respectively. If their expense ratios are 0.3% and 0.9%, then the running yields (yield minus expenses) are 5.7% and 5.6 %. Note how a large expense ratio has reduced the return to the investor.
Sourced : ET Money
Tips to Find the Best Liquid Fund
In evaluating a liquid fund, the main criteria of analysis includes returns, expense ratio, fund size, and extent of portfolio diversification.
- Returns: Since liquid funds invest in short term debt with maturities up to 91 days, investors should look at one-month or three-month returns to measure fund performance. Returns over a longer horizon (one/three years) are not meaningful for a liquid fund. A well-performing liquid fund should beat its benchmark as well as its peer funds, but investors must also verify that the fund has done well consistently. This can be checked by looking at one/three-month returns over the past few years.
- Expense Ratio: There is not much variation in the returns earned by liquid funds from different fund houses, because all these funds invest in similar short-term debt securities. Hence it is necessary to compare their expense ratios, which is the annual amount charged by the fund for managing the investment portfolio. The higher the expense ratio, the lower the final net return to the investor.
- Fund Size: Liquid funds are largely used by institutional investors. In case of a sudden large redemption by an institutional investor, a small liquid fund would lose a significant part of its assets, which in turn would adversely impact its ability to invest and generate returns. Hence liquid funds with relatively larger assets under management (AUM) are preferable to small-sized funds.
- Portfolio Diversification: Liquid funds are held for their ability to keep the invested corpus safe and stable. Thus, investors should evaluate the portfolio of a liquid fund to ensure that it is invested in several securities across different issuers. This will minimize the damage to the portfolio in case of default by any issuer.
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