FundsIndia explains : What are liquid funds

Liquid funds – another category of debt mutual fund is considered the least risky and is often quoted as a good alternative to savings account, to park your surplus. Let us look at various aspects of liquid funds in detail.

What it is
Liquid funds are open ended debt mutual funds that invest in very short term instruments having maturities of up to 91 days. They invest in treasury bills, money market instruments, commercial paper and certificate of deposits. These funds are supposed to be least risky as they ought to hold high quality papers in terms of rating. Liquid funds have the shortest of maturities among the various categories of debt funds. They earn returns simply from the coupon rate (accrual) on the instruments they hold. As their tenure is very short and they are not marked-to-market (except in rare circumstances), they are least volatile. The instruments in the fund are not traded and are held to maturity. That means while they do not swing with day-to-day yield movements, their returns will keep varying based on the coupon rate of the underlying instruments. For example: in a low interest rate scenario, the coupon rates of the underlying instruments will be low and hence returns will also be mediocre (although higher than your saving bank rate).

Ultra short-term funds and liquid funds – The difference
Ultra short-term funds cannot be substituted for liquid funds for the below reasons
• Ultra short-term funds hold papers with maturity greater than three months up to a year. They hold longer maturity instruments compared with liquid funds, some of which may be traded in the market. Hence the NAV could be impacted by the price movement of the underlying instrument as well
• Ultra short-term funds can be tad riskier to liquid funds in terms of the quality of paper they hold
• Some ultra short-term funds charge an exit load, while liquid funds across do not charge an exit load

Taxation
Liquid funds are taxed like any other debt fund. The profits realised in less than three years are taxed at your tax rate and the profits realised after three years are taxed at 20% with indexation. Investors in the 30% tax bracket can opt for a dividend payout in case of requirement of cash flows otherwise can opt for dividend reinvestment whereby the dividends are issued as new units of the fund thereby helping to reduce the capital gains tax. The rest may well opt for the growth option.

Advantages
Savings plus returns
Liquid funds have delivered over 6% (1 year, 10% tax slab post-tax category returns as of 15 Mar 2017– FundsIndia category) compared to meagre 4% on the money parked in your savings account.

Easy liquidity
You can redeem your liquid fund any time without any exit load. There are now special features in some funds that allow you to redeem it within a matter of an hour. Otherwise, based on the cut-off timings for redemption, you will receive the money the next day.

Low risk
Liquid funds are the least risky among the categories of mutual funds as the fund is invested in the safe papers such as treasury bills, certificate of deposit and commercial papers with A1+ ratings. While liquid funds are not usually marked to market, there can be exceptional cases of such mark down too, especially when one of the papers the fund holds has a downgrade (recent case in point being the downgrade of Ballarpur Industries’ papers to default status) or when there is a sharp up move of interest rate in the market and SEBI requires AMCS to mark-to-market their liquid funds (happened in July 2013).

There is not much differential in the performance of liquid funds barring a few basis points If you see a fund that performs far higher than peers, then make sure that the fund is not invested in slightly higher risk instruments. Remember, liquid funds are meant for parking your money safely and not for generating high returns. Hence, do not get swayed by marginally higher returns in this category.

Uses of liquid funds
Contingency fund: Liquid funds offer the best alternative to parking your surplus or creating a contingency fund compared with your bank account

Route to lumpsum investing: Liquid funds are a good option to park your lumpsum money and then systematically transfer (systematic transfer plan or STP) it to equity funds. Investing lump sum in the equities market may not be the most ideal thing to do when the markets are volatile or are richly valued. Under such circumstances, the money may be parked in a liquid fund with an instruction for STP into an equity fund at regular intervals. This helps to ride the volatility better thereby helping to average the investment over a period of time. At the same time the money is parked in a better returning option than savings account.