What are Liquid Funds ?

Liquid Mutual Funds are type of Debt Mutual Funds which lend to companies, governments for a short period of less than 91 days. Liquid Mutual funds invests into debt instruments like commercial papers, treasury bills, certificate of deposits. As the name suggests, the purpose of these funds is to get liquidity quickly i.e the investment can be converted into cash quickly without a significant drop in value. Also, the money can be withdrawn in 24 hours. Most importantly, you don't have to pay penalty (No exit load) for withdrawing like Fixed Deposits. According to SEBI rules, liquid funds NAV (Net Asset Value) is calculated for 365 days unlike other investments, which are calculated only on open market days.

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Advantages of Liquid Funds : A thumb rule is that Liquid Funds will give +2-3% returns than Fixed Deposits i.e returns in range of 7-10% without a significant risk. Liquid Funds are less risk prone and chances of drop in value is very less provided the Liquid Fund is not lending to risky businesses i.e companies with junk credit ratings. If you don't want a lock-in for your money and needs a easy access, then liquid funds are ideal choice. The average expense ratio is lowest across all mutual funds i.e in range of 0.1%-0.8% only.

Types of Liquid Fund : There are 2 types of Liquid Funds that are available. One is dividends Liquid Funds and other is growth Liquid Funds. The NAV of dividends Liquid Funds is almost constant i.e you will get regular dividends (Profits) and if you want to withdraw the principal amount, you can withdraw without a significant change in NAV. Incase of growth Liquid Funds, the dividends or interest earned are reinvested and NAV increases linearly (straight line with constant slope !!). Profit here is a difference in NAV while buying and selling. Following images will explain better.

Taxation : As they are debt funds, they will be taxed according to the tax rules for debt funds. For withdrawing gains before 3 years (Short Term Capital Gains), taxes will be as per income tax bracket. For withdrawing gains after 3 years (Long Term Capital Gains), taxes will be 20% after indexation (considering inflation).

Important Factors for choosing Liquid Funds : The most important factor for choosing Liquid Funds is to check the credit quality of debt investments done by funds. It is wise to not invest in Liquid Funds that have put money in risky assets. In lure of high returns, you may get trapped. If you need high returns from debt investment, better choose Credit Risk Funds. Another factor, is the expense ratio. One should choose Liquid Funds with less expense ratio. The goal of liquid funds is the ability to get liquidity easily and hence, past returns should have less priority and credibility of a AMC managing the Liquid Fund should have higher priority. HDFC, Kotak, SBI, Axis, ICICI are some known brands as of 2020.

Liquid Funds with STP : This is a strategy for investors to use. If you are also investing into Equity Funds, you can use the dividends returns from Liquid Funds to invest into Equity Funds using Systematic Transfer Plan (STP). Advantage of doing this is that you are not losing the principal value and are taking risk in Equity investments on the interest earned from Liquid Funds.

Thank You.

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