When it comes to mutual fund investments, we often think that equity-oriented funds are our only options. However, this is not true. The world of mutual funds has something to offer everyone. For investors looking for stable options other than fixed deposits, liquid funds can be an excellent way to diversify their portfolios. What are liquid mutual funds, and how do they work? Here’s everything you need to know about liquid mutual funds before investing.
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What are Liquid Funds?
A liquid fund is a type of mutual fund that invests in instruments like treasury bills, government securities, etc., that have a maturity of up to 91 days. Investors can invest in liquid funds for any duration. Liquid funds are super liquid; investors can withdraw money whenever they want.
Why Liquid Funds
Super Liquid: As the name suggests, the main aim of a liquid fund is to provide liquidity to the investor whenever needed.
No Exit Load: Equity mutual funds typically have an exit load of 1% if redeemed before one year. Liquid funds, on the other hand, charge a minimal, graded exit load—ranging from 0.0070% to 0.0045% if they are redeemed within seven days. There is no exit load if you redeem them after seven days.
Low risk: Liquid funds invest in securities maturing in 91 days, resulting in low interest rate risk. The fund manager selects high-quality, short-term instruments issued by reputable entities such as the Government of India or top-rated corporations, minimizing the risk of default.”
Better returns: Most people keep money in their savings accounts, which fetches around 2% to 3% interest, but if the same amount is kept in liquid funds, one can get up to 6% to 7% interest.
How do Liquid Funds Work?
The main aim of a liquid fund is to protect the investor’s money; the fund manager ensures this by choosing the highest-rated securities. They make sure that the average maturity of the portfolio is below 91 days, as per the rules.
Who Should Invest in Liquid Funds?
People looking to park their money for the short term: These funds are best suited for investors who are looking to park their money for the short term, as the average maturity of securities is less than 91 days.
Investors looking to maximise their returns: Investors who keep their money in banks should consider investing in liquid funds as they provide higher returns than savings bank accounts.
Investors looking to invest for emergency funds: The idea of an emergency fund is to have money set aside for unforeseeable emergencies. As liquid funds give better returns than savings bank accounts, super liquid funds are a good option for building emergency funds.
Taxation on Liquid Funds:
Liquid funds are a part of debt mutual funds and taxation on debt mutual funds in India. Capital gains tax is further bifurcated into short-term capital gain (STCG) and long-term capital gain (LTCG).
If investments in liquid funds are redeemed before three years, the investor will be taxed for STCG, which is taxed at the investor’s income tax slab. If a liquid fund investment is held for more than three years, it will be subject to LTCG, which for liquid funds is 12.5% without indexation.
Liquid Funds for STPs
Investors use liquid funds for systematic transfer plans (STP). In this process, they transfer money from a liquid fund to an equity fund when an opportunity arises, depending on market conditions. If the markets are expensive, funds are transferred from equity to liquid funds.
What are Arbitrage Funds?
Arbitrage funds try to generate returns by exploiting the price differences between the cash and derivatives markets. For example, if a stock trades at ₹100 in the cash market and ₹102 in the futures market, the fund manager buys the stock in the cash market and simultaneously sells it in the futures market, locking in a ₹2 risk-free profit. This strategy minimises market risk since positions are hedged.
How are Arbitrage Funds different from Liquid Funds?
- They invest in equity markets, while liquid funds invest in debt securities.
- A bit riskier compared to liquid funds
- Instant or next-day redemption for liquid funds compared to 1-3 days redemption
- No exit load after 7 days for liquid funds compared to 15 to 30 days for arbitrage funds.
Conclusion
Liquid funds are a great option for investors looking to earn a little higher return compared to savings account interest rates. But before directly investing in liquid funds, assess your goals, compare funds, and consult a financial advisor.
