Liquid Funds - Meaning, Benefits, & How They Work

Liquid Mutual Funds are a dynamic investment option worth considering. Let us delve into Liquid Funds, understand what they are, how they work and whether they are the right investment choice for you.

What are Liquid Funds?

Liquid funds, often referred to as Liquid Mutual Funds are Debt Funds that primarily invest in short-term debt instruments with very short maturity periods, often less than 91 days. These instruments can include government securities, certificates of deposit, commercial paper and more. Investors can quickly and easily redeem their units in these funds, often within 24 hours.

Investors are attracted to Liquid Funds because of their safety and stability. While they may not offer high returns associated with riskier investments, they are ideal for those seeking to park their funds temporarily, whether it is the bonus from your salary, an emergency fund or money being kept aside for a short-term goal.

Top Liquid Funds to invest in

Mahindra Manulife Liquid Reg-G

Mahindra Manulife Liquid Reg-G is for investors looking for a moderate-risk liquid fund and the benefit of a zero lock-in period. The returns have been one of the highest in this category in the last five years.

Axis-Liquid-G 

Axis Liquid-G is another recommended liquid fund that has generated decent returns for investors in the last two years. It is also a moderate-risk fund with no lock-in period. 

Aditya Birla SL Liquid Reg-G 

This liquid fund is best for investors who are looking to invest in a moderate-risk fund with a zero lock-in period. The return outputs have been good for the last five years. 

Quant Liquid-G 

Quant Liquid has been a consistently performing liquid fund over the last ten years. The fund has low to moderate risk, a zero lock-in period, and good return potential.

Franklin India Liquid Super Inst-G

Franklin India is a good option for liquid fund investments that has generated high returns in the last year. It is the second oldest liquid fund with low to moderate risk and no lock-in period. 

How do Liquid Funds work?

Liquid Funds pool money from various investors to generate steady, short-term returns while maintaining high liquidity. Professional fund managers manage the funds and decide where to invest the pooled money. The portfolio consists of a diversified mix of short-term debt instruments. These instruments have a relatively lower interest rate risk due to their shorter maturity.

The primary objective of Liquid Funds is to preserve the capital while delivering a reasonable return. Fund managers constantly monitor the fund's portfolio and make investment decisions that align with this objective. The short maturity period of the underlying instruments ensures that investors can easily access their funds when needed.

Advantages of Liquid Funds

Liquid funds provide you with several advantages, especially if you are an investor looking to strike a balance between liquidity, safety, and returns. Let’s discuss some of the major benefits offered by liquid funds:

Liquidity: Liquid funds provide a high degree of liquidity to investors, allowing easy conversion of their investments into cash with no major losses. With no lock-in period, you can access your funds quickly, with redemption requests usually processed within 24 hours.

Reduced Risk: Investing in high-quality debt securities considering short maturity periods, mostly up to 91 days, liquid funds minimise exposure to interest rate fluctuations. This short-term nature of investments is suitable for conservative investors who need stability in their profile.

Potential for Higher Returns: During inflationary periods, liquid funds offer steady returns to investors, making them an attractive option with modest but reliable returns.

Low Exit Loads and Expense Ratio: Managed by professionals with low expense ratios, liquid funds allow investors to maximise profitability. Additionally, with minimal exit loads, typically applicable for redemption within seven days, investors can access their funds without incurring substantial charges.

Tax Benefits: Liquid funds provide tax benefits to investors, with debt taxation applicable after a holding period of three years. Upon redemption, investors can enjoy indexation benefits, treating profits as long-term capital gains.

Who Should Invest in Liquid Funds?

Liquid funds are considered the best option for investors looking for stable investment options, with good returns. The following investors can consider investing in Liquid funds:

• Short-Term Investors: Individuals or entities willing to make short-duration investments with lower risks may find liquid funds appealing. One of the major reasons is the modest and low-risk returns, mostly up in 91 days.

• Cash Reserve Holders: Those holding surplus cash which they don’t require immediately can consider liquid funds. These funds provide an avenue for storing excess funds, offering slightly higher returns compared to the traditional way of investment.

• Investors Transitioning to Equity Funds: Liquid funds can help those investors who look to transition from conservative to more growth-oriented investments, including equity funds. The liquidity and stability of liquid funds make it an attractive option for investors who want to move towards higher risk gradually.

• Emergency Fund Builders: Many investors use liquid funds to have their emergency funds due to their low-risk nature, competitive returns, and high liquidity. These funds also offer quick access to funds when you have any unforeseen incident and need for money.

Ultimately, individuals, corporations, trusts, and institutions, looking for high liquidity, low-risk investment options with the potential for competitive returns can plan investment in liquid funds. However, investors should have detailed research and analysis which align well with their financial needs and circumstances.

Should you invest in Liquid Mutual Funds?

Liquid Mutual Funds are an excellent choice for investors seeking a balance between stability, liquidity and reasonable returns. Here are some scenarios where you might consider investing in Liquid Funds:

1. Temporary Parking of Funds

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   Liquid Funds are ideal if you have a lump sum amount and are planning to wait, to invest it. It provides better returns compared to a regular Savings Account, while keeping your funds easily accessible.

2. Safety and Predictability

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   Liquid funds are suitable if you prefer safety and predictability in your investments. They carry lower risks compared to many other types of Mutual Funds.

3. Quick Access to Funds

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   Liquid funds provide high liquidity, meaning you can redeem your investment quickly, often within a day. It makes them a reliable choice for short-term financial needs.

4. Slightly Higher Returns:

   While Liquid Funds may not offer exceptionally high returns, they provide better returns compared to a traditional Savings Account, making them an attractive option for those seeking a balance between safety and returns.

Factors to consider before investing in Liquid Mutual Funds in India

Before you decide to invest in Liquid Mutual Funds in India, several factors need to be taken into consideration, such as:

1. Investment Horizon :

   Liquid Funds are best suited for short-term financial goals or temporary parking funds. If you have a longer investment horizon, other types of Mutual Funds might be more suitable.

2. Risk Tolerance :

   While Liquid Funds are relatively low-risk, assessing your risk tolerance and ensuring that this investment aligns with your comfort level is essential.

3. Financial Goals :

   Clearly set your financial goals and assess whether Liquid Funds support these objectives. For long-term goals, other investment options may be more appropriate.

4. Liquidity Needs :

   Consider how quickly you need to access your funds. Liquid Funds offer high liquidity, but other factors, like processing time, can affect the speed at which you can access your money.

5. Safety of Investments :

   While Liquid Funds are considered safe, it is essential to understand the credit quality of the debt instruments in the fund's portfolio.

6. Potential Returns :

   While Liquid Funds aim to provide reasonable returns, these may be lower than the returns that Equity Funds offer. Make sure the potential returns align with your financial objectives.

Taxes on Liquid Funds

Taxes on liquid funds depend on how long you hold them. If you sell within 3 years, you'll face Short-term Capital Gains (STCG) taxed at your income tax slab rate. Hold for over 3 years, and you'll deal with Long-term Capital Gains (LTCG), taxed at a flat 20% rate, with indexation benefits.

A Liquid fund offers stability and adaptability, drawing in a diverse range of investors. They're low-risk and suitable for short-term goals or for diversifying a portfolio. Picking the right fund involves considering returns, expense ratios, fund size, and diversification. Moreover, understanding taxation is key to making informed investment decisions.

Thus, liquid funds have varying taxes based on how long you hold them: STCG within 3 years and LTCG after 3 years, with indexation benefits. 

Liquid Mutual Funds are a valuable addition to your investment strategy. They offer a temporary, secure way to park funds, providing security, liquidity and reasonable returns. To decide if Liquid Funds are the right choice for your wealth management, you need to carefully evaluate your financial goals and circumstances.