Liquid Funds – Meaning, Benefits, and How They Work

Most investors prefer to keep their extra cash in their bank’s savings accounts because they see them as safe and easy to access. But did you know that a liquid fund can offer a better alternative than your regular savings account for parking that surplus?

That’s right! These mutual funds not only provide higher returns but as the name suggests, also offer high liquidity at low risk. Here’s all you need to know about liquid funds to get started, from liquid funds meaning and working, to benefits, risks, and uses.

What are Liquid Funds?

Let’s begin by understanding the liquid funds meaning. A liquid fund is a kind of debt mutual fund that invests mainly in short-term money market instruments such as Certificates of Deposit (CDs), Commercial Papers (CPs), Treasury Bills (T-bills), and Collateralised Borrowing and Lending Obligation (CBLO). 

These securities mature in 91 days or less, which makes liquid funds a low-risk investment and a highly liquid option for risk-averse investors or investors looking to park their funds for a short time. Now that you know what is liquid fund is, let’s see how it works.

How Do Liquid Funds Work?

So how do liquid funds work exactly? The fund manager invests in short-term debt and money market instruments such as Treasury bills, commercial paper, and certificates of deposit. These instruments have a maturity period of up to 91 days and the fund manager makes sure that the average maturity remains somewhere around three months. 

There are three main goals that a liquid fund aims to achieve – Firstly, it aims to preserve the investors’ capital. Secondly, it aims to offer high liquidity to the investors, by investing in high-quality debt securities with short maturities. And thirdly, it seeks to generate returns higher than a savings account. 

The main source of income for liquid funds is interest payments on the short-term debt and money market instruments in which they invest. They also don’t have a lock-in period, however, a small exit load is charged if units are redeemed within seven days of purchase. The shorter maturity of these funds helps minimise interest rate risk, while the high credit ratings of the underlying securities minimise credit risk. This makes liquid funds the safest type of mutual funds.

Also Read: Safe Investment Options With High Returns In India 2024

Advantages of Liquid Funds

The many benefits of Liquid Funds are given below:

• Because most of the fund’s assets are invested in very short-term instruments, managers pick high-quality securities which minimise credit risk and interest rate risk.
• Investors can redeem their units within 1 working day, which makes liquid funds an ideal choice if you are looking for an option with high liquidity.
• A flexible holding period allows simple entry and exit.
• The expense ratio is much lower compared to other types of mutual funds.
• Liquid funds have no lock-in period which makes them a flexible investment option.
• The returns offered by liquid funds are higher than those by a savings account. 
• If you hold your liquid fund units for longer than 7 days, no exit load is charged.

Returns in Liquid Funds

The returns in liquid fund investments are not as attractive as hybrid or equity mutual funds, but they are higher than the returns offered by bank savings accounts. The exact percentage changes from time to time as it depends on the interest rates of the underlying securities, but generally it ranges from 5.5% to 7.5% per annum depending on market conditions.

The risk involved in Liquid Funds

Even though liquid funds have a reputation for being a safe option, a slight risk is associated with them. Certain types of risk in liquid fund investments are:

• Interest Rate Risk – If the prevailing interest rate in the market changes, the value of the securities held by the liquid fund can be affected. For example, if the interest rate rises, the existing securities earning lower rates become less attractive, which means the NAV drops. However, due to the short duration of the investments, the securities are never held long enough for the interest rate fluctuations to have a big impact on the overall value of the fund, which makes interest rate risk almost negligible.
• Credit Risk – This type of risk stems from the possibility that the issuers of the debt instruments in which the liquid fund has invested might default on their payments. Since fund managers invest in instruments with high credit ratings, this type of risk is also minimal.
• Inflation Risk – This type of risk arises when the investment doesn’t generate returns that are more than the inflation rate. If the returns from a liquid fund are lower than the inflation rate, the real value of your investment decreases.

How Should You Invest in a Liquid Mutual Fund?

• Before you invest in liquid mutual funds, several factors must be considered. Assess your financial goals and investment duration. For example, if your goal is to build an emergency fund, a liquid fund can be a very effective option. 
• After you’ve made sure your financial situation aligns with the features of liquid funds, research different funds available in the market. 
• Study and compare different funds based on criteria such as past performance, fund manager expertise, and track record, the credit rating of the underlying securities, AUM, AMC reputation, and expense ratios.
• You can make either a lump sum investment, or start an SIP (Systematic Investment Plan). For example, if you’ve received a large bonus, you may want to park it in a liquid fund to earn higher returns than offered by a savings account. Or, you can make smaller payments each month to work towards a short-term goal, like building an emergency fund.
• After you’ve invested, make sure to regularly monitor the performance of your liquid fund.

Why Should You Invest in Liquid Funds

There are many reasons to invest in liquid funds, such as:

• Building an emergency fund. In an emergency, you’d want to get access to funds as quickly as possible. Liquid funds offer high liquidity which is ideal for your urgent financial needs.
• If you receive a big bonus or a gift, you can park it in a liquid fund while you wait to determine how best to allocate the funds.
• Liquid funds are also suitable for achieving short-term financial goals, such as going on a family vacation.
• You can use liquid funds to stagger your investments into equity mutual funds through a Systematic Transfer Plan (STP). By consulting with a mutual fund investment planner, you can implement this approach effectively, slowly transferring money from a liquid fund to an equity fund over time.

Also Read: Understanding ELSS Funds: Meaning, Benefits & How They Work

Taxation Rules of Liquid Mutual Funds

Profits earned from liquid fund investments are taxable as ‘income from capital gains’. Here’s how liquid funds are taxed:

• Long-term Capital Gains (LTCG) Tax – If you hold liquid fund units for more than three years before redeeming, gains are considered long-term capital gains and taxed at a tax rate of 20% with indexation benefits.
• Short-term Capital Gains (STCG) Tax – If you sell liquid fund units within three years of buying them, the gains are considered short-term capital gains. These gains are added to your overall income and taxed as per your slab.
• Income Distribution Tax – If the fund offers dividends, they are also added to your overall income and taxed as per your slab.

FAQ on Liquid Funds

What do liquid funds mean?

Liquid funds are a kind of debt mutual fund in which the manager invests in highly liquid money market instruments with very short tenure. These funds are very low risk and due to the short maturity period (91 days) of the underlying assets, they provide high liquidity.

Who should invest in Liquid Funds?

Liquid funds can be attractive to investors looking for low-risk, highly liquid options. For example, individuals holding large amounts of uninvested cash, looking to park their money for the short term, or wanting a gateway to stagger their investments into the equity market can benefit from investing in liquid funds. 

Are liquid funds better than FD?

Liquid funds and short-term FDs offer similar returns. What makes liquid funds stand out, however, is that they don’t have a mandatory lock-in period. After the seven-day exit load period has passed, you can redeem your investment at any time without having to pay any exit load.

What does it mean when funds are liquid?

Liquid in this case refers to the liquidity of your investment. It means how quickly you can convert your mutual fund units into cash, without losing much value. Liquid funds allow you to redeem units within one working day.

How are Liquid Funds different from other mutual funds?

A liquid mutual fund is one of the ‘safest’ types of mutual funds. The investment is mostly made in high-quality, short-term debt instruments so the risk is very low and liquidity is very high compared to other categories of mutual funds such as equity funds, hybrid funds, ELSS, etc.

Is the Liquid Fund secure?

Yes, as far as mutual funds are concerned, liquid funds are extremely safe if you stay invested for a while. This doesn’t mean that they are risk-free, however. For example, a liquid fund may not be as safe as a short-term FD. If you invest with a reputed AMC, the risk of losing your capital is almost zero.

Are Liquid Fund returns guaranteed?

No. Liquid funds do not offer guaranteed returns.

Can I lose money in a Liquid Fund?

Investing in liquid funds does come with a slight risk, but the possibility of losing money by investing with a reputed AMC is almost zero.

How quickly can I redeem my investment in a Liquid Fund?

These funds are known for their liquidity. Your redemption request is processed within one working day.

What are the fees associated with Liquid Funds?

Usually, there is no fee associated with liquid funds other than a low expense ratio. If you redeem your investment within seven days of investing, you will also be charged a small exit load.

Which are the best Liquid Mutual Funds to invest in 2024?

You can assess the best mutual fund by assessing factors such as past performance, manager experience, AUM, and AMC’s reputation and performance. Connect with a Fincart mutual fund advisor today for more personalised recommendations!