What is Liquid Fund? Meaning, Benefits & Who Should Invest

Inflation is something we grapple with everyday. A spiralling inflation means a steady increase in the general price levels of goods and services over time. It erodes the value of money and reduces the purchasing power of your savings.What is worse, it outpaces the returns generated from our saving bank accounts, thanks to their relatively low interest rates.
As a result, the real value of your emergency funds decreases, compromising your ability to cope with rising costs during emergencies.Fortunately, there is a solution to this problem: liquid funds; these can effectively maintain and potentially grow your wealth.
Here, we learn more about liquid mutual funds returns detail.

Liquid funds, also known as money market funds, are debt funds that invest in highly liquid and debt securities of short tenures that provide high liquidity.
Under SEBI regulations, liquid funds can only invest in liquid money market and debt securities with a maturity of up to 91 days.So most liquid funds invest in low-risk instruments such as treasury bills, commercial papers, certificates of deposit, and other short-term debt securities.
The primary objective of these funds is to provide investors with a safe and convenient avenue to park surplus cash for the short term while earning a moderate level of returns.These funds are designed to offer high liquidity, meaning you can easily convert your holdings into cash within a short notice period, typically within one working day.
Liquid funds are popular among investors who seek an alternative to traditional savings accounts or fixed deposits, as they liquid mutual funds returns are better while maintaining a high level of safety and stability.As such, these will be suitable for you if you are looking for a temporary parking place for idle funds such as emergency funds, short-term savings, or funds earmarked for upcoming expenses.However, it is important to note that while liquid funds are considered relatively low-risk investments, they are not completely so. For instance, interest rate fluctuations can impact the returns on these funds.

As said earlier, liquid funds typically invest in short-term securities that are highly liquid and have good credit worthiness.
Under SEBI norms, they are required to hold at least 20% of their assets in liquid products so that redemptions can be met quickly.SEBI guidelines also mandate that liquid funds stay away from risky assets as identified by the market reguator. Plus, their overall exposure to a sector is limited to 20%.
A key characteristic of liquid fund is their earnings, which are mainly on account of interest payments, rather than by means of capital gains.This is because liquid funds don't register significant capital gains or losses when interest rates fluctuate, as they invest only in short-term securities, which limits their response to rate changes.
This also means if interest rates go up, liquid funds tend to outperform other debt funds because their interest earnings rise alongside, even as their their market values incur limited capital losses.

There are various advantages of investing in liquid funds, as listed below:

1. High liquidity: Liquid funds are designed to offer high liquidity, allowing you to convert your holdings into cash quickly, typically one working day. It makes them a convenient option for individuals or businesses when quick access to funds is required.
2. Safety and stability: The conservative investment approach of liquid funds – investing in highly liquid and low-risk instruments such as treasury bills and commercial papers – helps liquid funds preserve capital and provide stability. This makes these funds safer than other mutual fund categories that invest in riskier assets.
3. Moderate returns: While liquid funds prioritise capital preservation and safety, they still aim to generate a reasonable level of return. You can potentially earn higher liquid mutual funds returns than traditional savings accounts or fixed deposits, making liquid funds an attractive option for those seeking better yields on their short-term investments. Historically, liquid fund investments have yielded returns of 7-9% in India.
4. Diversification Liquid funds help you diversify by investing in a range of short-term debt securities, which helps mitigate the impact of defaults or credit risks associated with individual securities. This enhances the fund’s overall risk management.
5. Low entry barrier: These funds usually have a low minimum investment requirement, making them accessible to a wide range of investors. The feature allows you to invest with smaller amounts of surplus cash to participate.
6. Professional management: Liquid funds are managed by experienced fund managers making informed investment decisions to optimize returns.
7. Transparent and regulated: Liquid funds are subject to regulatory oversight, ensuring transparency and adherence to specific investment guidelines issued by the regulatory body SEBI. You can receive regular updates and reports on the fund's performance, holdings, and expenses, enabling them to make informed investment decisions.

As you must know, no investment is 100% risk-free and offers guaranteed returns. It is your money and ultimately you have to be responsible for protecting it. When investing, it is advisable to sit with an authrised financial advisor and check the areas listed below:

• Fund performance and track record: Evaluate the historical performance of all funds you consider. Look for consistent liquid mutual funds returns over different market cycles and compare a fund's performance against its benchmark and peer group. A fund with a solid track record of generating stable returns may be more reliable.
• Expense ratio and costs: Consider the expense ratio and associated costs of the liquid fund. The expense ratio implies the yearly fees charged by the fund house for the fund management. Lower expense ratios can potentially translate into higher net returns. Compare the expense ratios of different funds, and identify those with competitive costs.
• Credit quality and risk profile: Look for funds that invest in high-quality debt instruments issued by reputable entities. Assess the credit ratings assigned by rating agencies to understand the default risk associated with the fund's holdings. Lower credit risk can provide greater stability and safety.
• Exit load and redemption policies: Understand the exit load, if any, charged by the liquid fund upon redemption. Some funds may impose a fee for early withdrawals made within a certain period. Additionally, review the redemption policies and processing periods to ensure they align with your liquidity requirements.
• Risk assessment and investor suitability: While liquid funds are relatively low risk, they are not entirely risk-free. Conduct a comprehensive risk assessment to determine if the fund align with your risk tolerance and investment preferences.

When you invest in liquid funds, your earnings will be taxed twice: on receipt of dividends, and at the time of redemption. The rules for taxation on liquid funds , on both the earning are as follows:

Dividends

Earlier, any dividends paid by the companies were taxed at the distributor’s level, i.e. the company. After the Finance Act 2020, as an investor, you are taxed as per your income slab rate. Liquid funds example: if you get dividends for Rs 10,000, the income will be added to your total taxable income and you need to pay tax accordingly.

At the time of redemption

Before the budget 2023, debt funds were taxed as per the holding period, which can be either long-term or short-term.Investing in debt funds for a longer period of time helps investors benefit from indexation. But as per the new rules, all debt funds will be considered short-term debt funds if their exposure to Indian equities is less than 35%.However, such a change in tax rules does not really affect liquid funds as a type of short-term debt fund, because it will be taxed as per the slab rate.Your redemption amount will also be considered a short- term capital gain on which you need to pay tax at the rate of your income tax slab.

Liquid funds present an excellent opportunity to allocate surplus funds intended for emergency savings or specific short-term financial objectives.Compared to savings bank accounts, they can offer additional returns, providing a welcome boost to your financial goals.