What are Liquid Funds?

1. What are Liquid Funds?

Liquid funds are a type of debt funds that invest in financial instruments such as bank fixed deposits, treasury bills, commercial papers, and other debt securities with maturities up to 90 days. The NAV (Net Asset Value) of the liquid funds is calculated for 365 days, unlike other debt mutual funds where NAV is computed for business days only. Liquid funds have no restrictions of a lock-in period. The withdrawal of liquid funds is processed within 24 hours on business days. So, for all transactions received within cut-off time (say 2 p.m.), where the money is also realised within the cut-off time, then the units are allotted as per the NAV of the previous day. Liquid funds have the lowest interest risk associated with all the classes of debt funds. This is because they primarily invest in fixed income securities with a short maturity. Another notable benefit of liquid funds is that they do not have any entry or exit load.

2. Who should invest in Liquid Funds?

Since these funds provide liquidity and not high returns, it is advisable for investors searching for options to park their idle money to consider liquid funds as a viable option. However, investors should not invest their entire emergency corpus in liquid funds as the redemption of the funds will credit the money only on the next working day. Ideally, liquid funds are suitable for achieving short-term financial goals. Since some funds generate around 8% to 9% returns, they should be preferred over a regular savings bank account which offers returns in the range of 4% to 6%. The nature of liquid funds’ portfolio allocation is such that there is hardly any risk, volatility, or default associated, provided one invests in the high rated (AAA or AA) liquid funds.

3. Things to consider as an investor

a. Fund Objectives

Liquid funds are least risky among all the debt funds. The NAV doesn’t fluctuate too frequently as the underlying assets have maturity period in the range of 60 days to 91 days. This prevents the NAV of liquid funds from getting impacted by the underlying asset price fluctuations. However, there might be a chance of a sudden drop in NAV. This can happen due to a sudden decline in the credit rating of the underlying security. In simple words, liquid funds are not entirely risk-free.

b. Expected Returns

Historically, liquid funds have offered returns in the range of 7% to 9%. It is way higher than the mere 4% returns obtained on a regular savings bank account. Even though the returns on liquid funds are not guaranteed, in most cases, they have delivered positive returns on redemption.

c. Cost

Liquid funds levy a fee to manage investments, called ‘expense ratio’. The Securities and Exchange Board of India (SEBI) has mandated the expense ratio to be under 2.25%. Considering the hold till maturity strategy of the fund manager, liquid funds maintain a lower expense ratio to offer comparatively higher returns over a short period.

d. Investment Horizon

Liquid funds are exclusively for investing the surplus cash over a short duration, say up to three months. Such a short horizon helps to realise the full potential of the underlying securities. In case you have a longer investment horizon of up to one year, then you may consider investing in ultra-short-term funds to get relatively higher returns.

e. Financial Goals

If you want to create an emergency fund, then liquid funds can prove to be very useful. Also, you receive higher returns, and this will help you to take out your money quickly in case of emergencies.

4. How to evaluate Liquid funds?

a. Fund Returns

Fund performance plays a significant role in the selection of relevant funds. You may seek funds that have delivered consistent returns over different time horizons. Choose the funds that have outperformed their benchmark and peer funds consistently. However, you must analyse the fund performance, which matches your investment horizon to get relevant results.

b. Fund History

Track record of the fund house is an essential criterion while selecting a fund. Fund houses that have a strong history of consistent performance in the investment domain may be trusted to stay resilient during slumps and market rally. A fund house which has a consistent track record for at least 5 to 10 years is the one you can choose.

c. Expense Ratio

Expense ratio indicates the operating efficiency of a mutual fund scheme. It shows how much of your investment is used to manage the expenses of the fund. A lower expense ratio interprets into a higher take-home return for the investor. Choose a fund with a lower expense ratio, which can give you better performance.

d. Financial Ratios

In addition to using plain vanilla returns, there is a range of financial ratios available, which can be used to analyse the performance of the fund from different perspectives. You may use tools such as standard deviation, Sharpe, alpha, and beta ratios to examine the risk-adjusted returns and relative riskiness of a fund. A fund having higher standard deviation and beta is riskier than a fund with lower beta and standard deviation. Look for funds having a higher Sharpe ratio which means it gives higher returns on every additional unit of risk taken.

5. Top 10 Liquid Funds in India

When selecting a fund, you need to analyse the fund holistically. Various quantitative and qualitative parameters can be used to arrive at the best liquid funds as per your requirements. Additionally, you need to consider your financial goals, risk appetite, and investment horizon in mind. The following table shows the top 10 liquid funds in India based on the returns in the last three years. Investors may choose the funds based on different investment horizons like three years or ten years returns. You may consider other criteria such as financial ratios as well.