Liquid Funds

Liquid funds are debt funds that invest in short‐term assets such as treasury bills, government securities, repos, certificates of deposit, or commercial paper. According to SEBI norms, liquid funds are only allowed to invest in debt and money market securities with maturities of up to 91 days.

The return of a liquid fund depends on the market price of the securities held by the fund. However, since prices of short‐term securities do not change as much as long term bonds, the returns of liquid funds are relatively more stable as compared to other debt funds.

To understand how liquid funds work, you need to know where they invest and how they generate returns.

• Where do Liquid Funds Invest:

  A liquid fund will typically hold securities that are short term, of good credit quality, and highly liquid. A recent set of guidelines issued by SEBI has helped to reinforce these fund features.
  Liquid funds can invest only in listed commercial paper, and they have an overall exposure limit of 20% in a sector. They are not permitted to invest in risky assets as defined by SEBI norms. These norms aim to contain credit risk in the liquid fund portfolio.
  Further, liquid funds must hold at least 20% of their assets in liquid products (cash and cash equivalents such as money market securities). This ensures that they can quickly meet any redemption demands.

• Sources of Earnings:

  Liquid funds earn mainly through interest payments on their debt holdings; a very small part of their income is generated via capital gains. This is a defining feature of liquid funds, so let us understand it in some detail.
  When interest rates fall, bond prices go up. When interest rates rise, bond prices fall. The negative relation between bond prices and interest rates is stronger for long term bonds. This means that the longer the maturity of a bond, the more it responds to changes in market yields.
  Since a liquid fund invests only in short term securities, it's market value does not respond much when interest rates change in the market. This means that liquid funds do not have significant capital gains or losses. In a rising interest rate environment, liquid funds often outperform other debt funds because (i) their interest earnings are going up (ii) their market values suffer only to a limited extent due to capital losses. In market jargon, we say that liquid funds have a very low-interest rate risk.

• Low Risk:

  A liquid fund is a low-risk debt fund which focuses on providing safety of principal and steady returns. As a result, the value of a liquid fund is fairly stable across different interest rate cycles in the market. In contrast, funds holding longer‐maturity securities can swing between earning strong capital gains when rates are declining, to making heavy capital losses when rates are rising.

• Low cost:

  Liquid funds are low-cost debt funds, mainly because they are not as actively managed as some of the other debt funds. In practice, most liquid funds operate with expense ratios below 1%. This low‐cost structure allows them to maximize the effective return to the investor.

• Flexible holding period:

  An investor in a liquid fund can hold his or her investment for as long as necessary. Though a small exit load is charged for redemption within seven days, liquid funds have flexible holding periods. This makes it easy to enter and exit the investment while earning safe, market‐linked returns for the duration of the investment.

• Quick Redemption:

  Redemption requests are processed within one working day; some funds even offer an instant redemption facility. This is possible as liquid funds are invested in highly liquid securities with a low default probability.

• Investors with a short investment horizon:

  Liquid funds are best suited for those with an investment horizon of up to 3 months, as the funds invest in securities with comparable maturities. Investors with longer investment horizons‐ say 6 months to a year‐ should invest in slightly longer duration funds (say ultra-short duration funds) so that they can earn higher returns.

• Investors who invest in bank deposits:

  Investors who keep their surplus funds in bank deposits can benefit from liquid funds on two fronts: greater withdrawal flexibility and better returns. In a traditional bank fixed deposit, funds are locked‐in for a fixed period; and an interest penalty is imposed on premature withdrawal. In contrast, liquid funds offer flexible holding periods with easy exit options. Money in bank savings accounts can be withdrawn at any time, but they offer around 3%‐4% interest only, which is lower than the 5% plus usually earned by a liquid fund.

• Investors who want to keep Contingency Funds:

  The purpose of liquid funds is to provide liquidity and safety while generating a low return. Hence investors can park an emergency or contingency corpus in a liquid fund, with the assurance that it will be safe and can be redeemed when necessary.

• Investors who need to Park Funds Temporarily:

  Liquid funds are cash management products that are designed to keep funds safe while earning a small return. Hence, a large sum of money, say, from a bonus or sale of property or inheritance, can be temporarily parked in a liquid fund until the investor decides how to invest the corpus.

• Medium to Route investments in Equity Funds:

  Investors can hold funds in a liquid fund and use an STP to route investments systematically into an equity fund. This enables them to invest in equity periodically, while at the same time, the corpus in the liquid fund earns stable returns.

Liquid funds are among the least risky debt funds and often viewed as substitutes for bank deposits. However, low risk does not mean zero risks! Investors should understand that liquid funds also carry a few risks.

First, like all mutual fund products, returns are not guaranteed. Bank deposits will always pay the promised interest amount on maturity, but the return from a liquid fund is variable because it depends on market interest rates. That is why investors should check the track record of a fund and opt for funds with consistently good performance.

Second, liquid funds are not immune to credit risk. During the IL&FS downgrade in 2018, it was discovered that some liquid funds had invested in lower-rated debt securities to boost their returns. When these securities defaulted on interest payments, their credit rating was downgraded, and the liquid funds lost market value. Investors can reduce credit risk by choosing liquid funds with the highest quality portfolios.

Third, liquid funds are not wealth-creating products; rather, they provide safety and liquidity for a modest return. Investors must ensure that their financial goals and return expectations are in tune with the features of liquid funds.

Finally, liquid funds must be evaluated based on returns as well as expense ratios. Liquid funds are mainly generic products, so most liquid funds earn similar returns at any given time. Therefore, a fund with a high expense ratio will end up with significantly lower returns. For example, consider two liquid funds with yields of 6% and 6.5% respectively. If their expense ratios are 0.3% and 0.9%, then the running yields (yield minus expenses) are 5.7% and 5.6 %. Note how a large expense ratio has reduced the return to the investor.

Investors earn dividends and capital gains from liquid funds. Investors do not pay any tax on dividend income from mutual funds. In case an investor earns a capital gain- by redeeming the units of the fund at a price higher than his or her purchase price- then the capital gains are taxable.

• Short term capital gains:

  If an investor sells or redeems the units of a liquid fund after a holding period of up to 3 years, he or she is deemed to have earned short‐term capital gains. This is taxed at the income tax slab rate applicable to the investor.

• Long term Capital Gains Tax:

  If a liquid fund is redeemed/sold after being held for more than 3 years, the capital gain is treated as a long-term capital gain, and the investor gets the benefit of "indexation." This means that the purchase price is increased to adjust for inflation (using an index provided by the Government) before calculating the capital gain. Long term capital gains are currently taxed at a rate of 20%.

In evaluating a liquid fund, the main criteria of analysis include returns, expense ratio, fund size, and extent of portfolio diversification.

• Returns:

  Since liquid funds invest in short term debt with maturities up to 91 days, investors should look at one-month or three-month returns to measure fund performance. Returns over a longer horizon (one/three years) are not meaningful for a liquid fund. A well-performing liquid fund should beat its benchmark as well as its peer funds, but investors must also verify that the fund has done well consistently. This can be checked by looking at one/three-month returns over the past few years.

• Expense Ratio:

  There is not much variation in the returns earned by liquid funds from different fund houses, because all these funds invest in similar short-term debt securities. Hence it is necessary to compare their expense ratios, which 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 are largely used by institutional investors. In case of a sudden large redemption by an institutional investor, a small liquid fund would lose a significant part of its assets, which in turn would adversely impact its ability to invest and generate returns. Hence liquid funds with relatively larger assets under management (AUM) are preferable to small-sized funds.

• Portfolio Diversification:

  Liquid funds are held for their ability 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. This will minimize the damage to the portfolio in case of default by any issuer.

The above table shows the top 5 liquid funds ranked on the basis of 1-month and 3‐month returns. As expected, the funds have not earned widely different returns. But there is some dispersion in expense ratios.

If a fund charges a higher expense ratio, investors should check if its returns are good enough to compensate for the higher expense. Investors must also keep fund size in mind‐ a small fund may outperform other larger funds (as in this table), but a large liquid fund is likely to have more stable returns over the long term. Also note that returns for periods under one year are absolute returns, which means that they have to be annualized to be comparable with other returns. For example, a one-month return of 0.77% can be annualized as follows: 0.77% x (365/7) = 9.4%.

• Liquid funds are debt funds that invest in debt and money market securities with maturities up to 91 days.
• Liquid funds invest in short term, good quality, and liquid securities; hence, the value of their units tend to be less volatile as compared to other debt funds. Fund returns are primarily from interest earnings; capital gains form a very small part of total returns.
• Liquid funds are a liquid, low cost, low‐risk product with flexible investment options.
• Liquid funds are designed to provide safety of principal and liquidity, and a modest return. Hence they are often viewed as substitutes for short term bank deposits.
• Liquid funds are most suitable for investors with a short investment horizon, those who want to park a large corpus temporarily, or for use as a medium to route funds into other long‐term funds.