Liquid Funds: Definition, Taxation and More

Liquid fund is a type of debt mutual fund. According to the Association of Mutual Funds in India(AMFI), mutual fund is a pool of money managed by a trust that collects money from a number of investors sharing similar investment objectives and invests the same in equities, bonds, money market instruments, and/or other securities.

Mutual funds offer a diverse choice of investment options. There are mainly 3 types of mutual funds, Equity, Debt and Hybrid. The investor can choose a suitable option depending on the risk appetite, duration of investment, individual financial goals, etc. Debt funds are further classified into 18 types prevailing in the market which suits the diverse needs of the investor. Lets discuss what is liquid fund in detail.

Liquid fund is one type of debt fund that invests in short term money market instruments which generates fixed interest. Treasury bills, certificates of deposit, commercial paper, and so on are some of the examples of the underlying securities in the portfolio of a liquid fund. 

Liquid funds are considered as “least risky” among all classes of debt funds as they mostly invest in fixed income securities that mature soon. They are suitable for investors who don’t want to take high risk.

How do Liquid Funds Work?

Liquid funds provide a high degree of liquidity and safety of the capital for investors. To provide safety and liquidity, the fund manager invests in high-rate debt instruments that mature within 91 days. The allocated proportions are as per the fund’s investment objective. Three months of average maturity of the portfolio is assured by the fund manager. This reduces the sensitivity of fund returns to interest rate movements and makes them less vulnerable.

The fund value of liquid fund does not experience a lot of fluctuations. The maturity of the underlying securities is matched with the maturity of the portfolio. So, it helps to deliver higher returns. Liquid funds carry low risk and give higher return compared to saving bank account. These funds don’t have a lock-in period. So investors can invest idle money in liquid fund and use it as regular saving bank account but with better returns.

Types of Money Market Instruments

Certificate of Deposit (CD)	Offered by scheduled commercial banks, CDs provide interest rate premium against lumpsum deposit invested by investor for pre determined time. It is same like Fixed Deposit, the only difference between FDs and CDs is you cannot withdraw CD before expiry date.
Commercial Paper (CP)	Commercial Paper is short-term unsecured promissory notes issued by companies or other financial institution that have a high credit rating. Investors earn profit by issuing at discounted rate and redeeming it at face value.
Treasury Bills	Treasury bills are issued only by the central government when the government needs money for a short period. The interest on them is determined by market forces.

Who should invest in Liquid Funds?

1. Liquid funds are best suited for those with short investment horizon.

2. Investors who keep their surplus funds in bank deposits can invest in liquid funds. This type of debt fund provide greater withdrawal flexibility as compared to Fixed Deposit(FD) and better returns as compared to saving bank account.

Funds are locked‐in for a fixed period and an interest penalty is imposed on premature withdrawal in Fixed Deposit. But, liquid funds offer flexible holding periods with easy exit options. Money in bank savings accounts can be withdrawn at any time, but saving accounts offer around 3%‐4% interest only. Whereas liquid fund offers 5% plus interest.

3. The purpose of liquid funds is to provide liquidity and safety but generates low return. Investors can park an emergency fund in a liquid fund, with the assurance that it will be safe and can be redeemed when necessary.

Things to Consider Before Investing in Liquid Funds

1. Risk: Liquid funds are low risk investment but it carries some risk. NAV doesn’t fluctuate too frequently as the underlying assets mature within 60 days to 91 days. So, for these funds, NAV doesn’t fluctuate so much. But if credit rating of underlying asset goes down then it can affect liquid fund.
2. Return: Bank account gives less return but the interest rate is promised. Interest rate of liquid fund depends upon the market. So, investors should check the track record of liquid fund before investing.
3. Cost: All mutual funds charge a small fee, expense ratio to manage investment. Liquid funds maintain a low expense ratio to offer comparatively higher returns over a short term.
4. Financial goal: Liquid funds are not wealth creation investment option. They provide liquidity with moderate return. Also, these are short term investment. So, if investor should know financial goals before investing in such type of fund.

Tax on Liquid Funds

Investors earn dividends and capital gains from liquid funds.

• Dividends earned are added to income of investor and taxed according to his income tax slab.

• The tax on capital gain depends upon how long investor stay invested in fund. If an investor sells or redeems the units of a liquid fund within a holding period of up to 3 years, the income generated is long term capital gain. It is taxed at the income tax slab rate applicable to the investor.
• If a liquid fund is redeemed/sold after 3 years, the capital gain is treated as a long-term capital gain, and the investor gets the benefit of “indexation”. The purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain.

How to Find the Best Liquid Fund

To evaluate a liquid fund, investor should analyze returns, expense ratio, fund size, and extent of portfolio diversification.

• Returns: Since liquid funds invest in short term debt instrument with maturities up to 91 days. So, investors should look at one month or three month returns to measure fund performance of different funds, not the long term returns. Performance of individual fund is also measured by looking at one to 3 months return of fund in past few years
• Expense Ratio: Compare expense ratio of different liquid funds. Expense ratio 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 with relatively larger assets under management (AUM) are preferable to funds with small AUM. Liquid funds with small AUM will lose a significant part of its assets in case of a sudden large redemption by an institutional investor. It affects fund’s ability to invest and generate returns.
• Portfolio Diversification: Liquid funds try 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 to minimize the damage to the portfolio in case of default by any issuer.

Pros of Liquid Funds

Following are advantages of liquid funds:

1. Low cost: The liquid funds are not actively managed fund like most other debt funds. So, the expense ratio of these funds is on the low as compared to other debt funds.
2. Low risk: As we read above, liquid funds carry low risk as the underlying securities mature within 91 days. So, it reduces volatility too.
3. Flexibility: Liquid funds are open ended mutual funds. Therefore, you can redeem your units at any time.
4. Faster processing: The redemption requests are generally processed within a working day. Some liquid funds provides facility of instant redemption.

Takeaway:

We read what are liquid funds, how do they work, who can invest in it, advantages of liquid fund and how to find the best liquid fund. Liquid funds are a liquid, low cost, low‐risk product with flexible investment options. So, investors who want to invest emergency fund or surplus amount in low risk option then liquid fund is a good option. It generates more return as compared to saving bank account and redeemed any time. So, you should know your financial goals and risk capacity before selecting any fund.