What Is Liquid Fund – Meaning, Risks, Returns & its Benefits

Liquid funds are one of the most popular types of debt funds, designed to provide investors with high liquidity and relatively stable returns. They are ideal to park surplus funds for shorter durations, offering easy money access with minimal risk involved. Here is a thorough guide to understanding liquid funds, their benefits, and how to invest in these funds effectively.

Overview Liquid Funds

Liquid funds: Liquid funds are debt funds that invest in short-term money market instruments that have a maturity period of up to 91 days. These instruments include treasury bills, certificates of deposit, commercial papers, and other highly liquid assets. The basic goal of liquid funds is to provide capital safety and easy accessibility while generating modest returns.

How Liquid Funds Work

Liquid funds work by gathering funds from several investors and then investing them in high-quality, short-term money market instruments. These are not sensitive to market movements due to the short maturity period; thus, liquid funds tend to be stable. Fund managers would, therefore, focus on keeping liquid funds liquid and taking little risk so that an investor can withdraw their money if needed.

The NAV of liquid funds is calculated daily but shows minimal fluctuations because of the low-risk nature of the underlying assets. Liquid funds are, therefore, ideal for short-term financial needs or as an emergency fund.

How to Invest in Liquid Funds

Liquid funds are easy to invest in. Here’s how:

Choose a Fund:

Research and select a liquid fund based on past performance, expense ratio, and credit quality of the portfolio.

Open an Account:

If you do not have an account, open a mutual fund account with an asset management company (AMC) or through a mutual fund distributor or platform.

KYC:

Update your Know Your Customer (KYC) details. This is a must for all mutual fund investments.

Online and Offline Investing:

AMC websites, mutual fund websites, or mobile applications allow online investments. You can also get the physical application form and submit it at an AMC office or distributor’s office.

Track your investment. Most liquid funds do not need active management.

Benefits of Liquid Funds

The several benefits of investing in liquid funds are:

High Liquidity:

Liquid funds offer immediate access to money, with withdrawals often being processed within 24 hours on business days.

Low Risk:

These funds invest in high-quality, short-term instruments, which makes them less volatile compared to other mutual funds.

Better Returns than Savings Accounts:

Liquid funds usually offer better returns when compared to traditional savings accounts, making them a better option for idle cash.

Lock-In:

Unlike other fixed deposits, liquid funds offer no lock-in period so as to provide flexibility to the investor.

Costs:

Minimal entry and exit loads of most liquid funds ensure hassle-free transactions.

Ideal for Emergency Funds:

Liquid funds are apt for building an emergency fund as they are highly liquid and generate stable returns.

Who Should Invest in Liquid Funds?

These funds can be a suitable choice for the types of investors listed below:

Short-term investors:

Liquid funds are ideal if you want to park your money for a short duration, like a few days to a few months.

Emergency fund seekers:

Liquid funds are apt for saving money for unforeseen expenses.

Low-Risk Takers:

Investors who focus more on capital safety than returns will like liquid funds.

Spare Change Investors:

If you have spare change in your savings account, you can find better returns on liquid funds without losing the liquidity benefit.

Bridge Investors:

Investors looking for a temporary parking space before committing to long-term investments will like liquid funds.

Things to Keep in Mind Before Investing in Liquid Funds

There are some crucial things you need to keep in mind before making the investment:

Returns are Not Inflexible:

Although the returns are stable, they are not fixed in nature and are susceptible to market conditions.

Interest Rate Risk:

Though negligible in nature, the returns generated by liquid funds can suffer due to interest rate fluctuation.

Expense Ratio:

A lower expense ratio offers higher take-home returns. Always compare expense ratios for different funds.

Taxation:

Liquid funds are also liable to capital gains tax, which impacts the overall net returns.

Credit Risk:

Although low, it has the potential of defaulting if a debt issuer defaults.

Investment Horizon:

Liquidity funds are the most suitable for short-term usage. Other mutual fund schemes can be opted for higher time periods.

Fund Manager Expertise:

The overall performance of the fund will be contingent on the choice of quality instruments made by the fund manager.

Taxation Rules of Liquid Funds

STCG & LTCG:

STCG and LTCG on liquid funds (a sub-category of debt funds) are as per investors’ tax slab.

Dividend Distribution Tax (DDT):

The dividends received from liquid funds are taxable in the hands of investors at their applicable income tax percent rate.

By understanding these concepts, you will be better equipped to plan your investments and minimize tax liabilities.

Conclusion

Liquid funds are a safe and great way to manage surplus cash and short-term financial needs. With their high liquidity, low risk, and potential for better returns compared to traditional savings accounts, they are an excellent add-on to any investment portfolio.

However, it’s essential to evaluate your financial goals, risk tolerance, and investment horizon before investing.

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