Liquid funds are one of the lesser-known categories of mutual funds in India. They are debt funds that invest in short-term money-market instruments like commercial papers, treasury bills, and so on. What makes liquid funds different from debt funds is that it invests only in fixed-interest generating instruments that mature within 91 days.

Here, in this guide, we give you all that you need to know about liquid funds – their features, working, benefits, who should invest, how to invest, returns, top-performing liquid funds and more.

What are liquid funds? 

As the name implies, liquid funds offer high liquidity, as the fund manager invests your capital in high-interest generating debt instruments. The asset allocations are done based on the fund's objectives. Generally, liquid funds are very short-term funds, and the average maturity time is just three months.

Since liquid funds are very short funds, it is not affected by the long-term changes in interest rates. Also, liquid funds do not experience fluctuations, thereby guaranteeing the safety of your capital. Another reason why liquid funds generate higher returns is that the maturity of the securities in the portfolio matches the maturity of the fund.

To summarise, liquid funds are an excellent option to park your idle funds. Since these mutual funds are low-risk and offer high returns, they are the better option when compared to depositing extra funds in a savings bank account. Another considerable advantage of liquid funds is that they don't have any exit loads, and you can withdraw your money anytime as per your convenience.

Types of Money-Market Instruments that Liquid Funds Invest In

Before you invest in a liquid fund, you should be aware of the different money-market instruments that these funds invest in. 

  1. CD (Certificate of Deposit) 

A CD is similar to a bank fixed deposit. CDs are offered by commercial banks and are timed deposits. One main difference between a fixed deposit and a certificate of deposit is that withdrawals are not permitted on the CD before the maturity period. 

  1. CP (Commercial Paper) 

Financial institutions and companies that have a high credit rating offer commercial papers (also known as promissory notes). These are unsecured money-market instruments that are issued at discounted rates but redeemed at face value, thereby earning a profit.

  1. T-Bills (Treasury Bills) 

The govt of India uses treasury bills to raise short-term funds, usually up to 365 days. T-Bills are one of the safest money-market instruments as the government of India backs them. When compared with other conventional money-market tools, the rate of return (the risk-free rate) is also low.

Are liquid funds ideal for you? 

Liquid funds do not work for all investors. If you are looking to achieve your long-term financial goals, then these funds are not the right choice for you. Liquid funds work well for investors who have idle cash in hand and are looking for short-term investment options.

Liquid funds generate higher returns compared to regular bank savings accounts. Generally, most liquid funds offer bonus, performance-based incentives and other gains.

Another option to use liquid funds is to help you get started with equity investing. Some investors are worried about investing lumpsum in equity funds, as it increases risk exposure. The alternative is to park your funds in a liquid fund and then transfer the capital via SIP to an equity fund. This reduces sudden exposure of a large amount to equity. 

Benefits of Liquid Funds 

  • Minimal lock-in period – Ranging from 3 days to 3 months 

  • Instant liquidity – as there are no exit loads 

  • Capital protection – as the fund invests in safe debt instruments 

  • Instant withdrawals – the amount accumulated is disbursed to your account within 24-hours of redemption 

  • Tax-efficient – helps investors reduce their tax burdens

Factors to Consider before Investing in Liquid Funds 

  • Liquid Funds are Relatively Low Risk but not entirely Risk-free 

Fluctuations in the NAV (Net Asset Value) are what causes the inherent risks in mutual funds. When it comes to liquid funds, the NAV is not susceptible to fluctuations, as the underlying assets mature within a short period – usually within 60 to 91 days. 

While liquid funds are relatively low risk, it doesn’t mean they are 100% risk-free. The fund value can drop drastically due to sudden changes in the credit ratings of an underlying asset. 

  • Higher Returns than Bank Savings Account 

On average, the returns generated from liquid funds range from 7 to 9%. This is significantly higher compared to the 4% returns generated from a regular savings bank account. Though liquid funds do not guarantee profits, historically they have offered net positive returns on maturity.

  • Low Expense Ratio 

Just like all other mutual funds, liquid funds charge an expense ratio. This is the fee charged by the fund house for managing your investments. However, you don’t have to worry about high expense ratios as the SEBI has fixed the upper limit at 1.05%. As a result, liquid funds offer higher returns in the short-term. 

  • Short Investment Horizon 

As mentioned above, liquid funds are ultra-short-term funds that have an investment horizon from two to three months. So, if you're a long-term investor, then these funds are not the right fit for you.

  • Ideal for building your Emergency Corpus

Liquid funds come in handy when you're trying to build an emergency fund. Besides earning higher returns, you can also quickly withdraw your funds without any exit penalties in case of emergencies.

  • Tax Implications 

Since liquid funds are a type of debt funds, the taxation rules for debt funds are applicable here. Taxation of debt funds depends on the duration for which you stay invested in it. Gains earned during the first three years of investment are known as STCG (short-term capital gains), and the profits made beyond that are classified as LTCG (long-term capital gain).

Since liquid funds have a short maturity period, they attract only STCG. The short-term gains earned from liquid funds are added to the investor's taxable income and taxed as per his/her income tax slab.

Best Performing Liquid Funds in India 

S.No. Fund Name Average Returns
1 Axis Liquid Fund – Growth 7.47%
2 Aditya Birla Sun Life Liquid Fund – Growth 7.49%
3 ICICI Prudential Liquid Fund – Growth 7.40%
4 L&T Liquid Fund – Growth 7.37%
5 UTI Liquid Fund – Growth (Cash Plan) 7.47%

*Note that returns from these funds are subject to change based on market fluctuations. Make sure to choose funds based on your investment goals. 

How to invest in a liquid fund? 

Different fund houses in India offer liquid funds. Make sure to analyse the scheme based on various parameters to choose the right fund that suits your specific requirements. Once you have zeroed in on your preferred fund, visit the website of the AMC. Fill up the fund application form, provide the necessary KYC documents and start investing. 

Liquid Funds: FAQs

  1. Do liquid funds offer guaranteed returns? 

Just like all other mutual fund investments, liquid funds do not offer 100% guarantee on returns. However, a look at the average performances of liquid funds shows that these funds historically generate higher returns compared to bank deposits. 

  1. Why doesn’t the NAV of liquid funds fluctuate?

The NAV of other mutual funds is calculated daily – at the end of a working day. Hence, they fluctuate often based on market conditions. On the other hand, the NAV of liquid funds is calculated only once every 365 days, making it relatively stable.

  1. Is there any limit on how much an individual can invest in liquid funds? 

Yes. Investors can invest only up to Rs. Ninety lakhs in liquid funds.

EndNote 

Park your Idle Funds in a Liquid Fund & Earn High Returns

If you have some extra money in hand, you can invest in liquid funds for the short-term and generate higher returns. Make sure to understand the fund scheme thoroughly – risk levels, asset allocation and more, before you choose a liquid fund.