All About Liquid Mutual Funds

The primary aim of liquid funds is to provide a high degree of liquidity and ensure capital protection. Here is how they work:

• Investments:Liquid fundsinvest in high-credit quality debt instruments such as certificate of deposits, commercial papers, treasury bills, etc.
• Maturity: The fund manager ensures that the average maturity of securities that comprise the portfolio is up to 3 months.
• NAV: Unlike some other funds, theNet Asset Value (NAV)of a liquid fund does not fluctuate much; this is because of low duration high quality securities that make up these funds.
• Withdrawals: Withdrawals from a liquid fund are typically processed in 24 hours.

Liquid funds offer the following benefits:

• No lock in: There is no penalty for withdrawing money from a liquid fund nor is there any lock-in period like a fixed deposit.
• Entry/Exit loads: There is no entry load. The exit load normally is Nil, however can be levied as mentioned in Scheme Information Document
• Lowest interest rate risk: Liquid mutual funds carry the lowest interest rate risk because of their high liquidity and investments in high credit rated securities.
• No taxes on dividends: Liquid fund dividends are not taxed in the investor's hands, but dividend distribution tax applies.

Disadvantages of liquid funds

While you have understood what are liquid funds and the qualities of best liquid funds, it is also important to know about its disadvantages, to ensure that you have a holistic understanding of liquid funds meaning ultra short-term funds. Following are some disadvantages that may affect even the best liquid funds –

One notable disadvantage is the potential for relatively lower returns compared to other investment avenues. When you read about what are liquid funds, you came to know that the primary objective of liquid funds is capital preservation and providing quick access to funds. Due to this, their returns tend to be modest in comparison to riskier assets. Additionally, although liquid funds are deemed low-risk, they are not entirely devoid of risk. While rare, there is a possibility of credit risk associated with the underlying securities held by the fund. Another downside is the impact of taxes on returns. While these funds are considered tax-efficient due to their short investment horizon, they are subject to taxation, which can reduce the net returns. Moreover, changes in interest rates can influence the returns of liquid funds, with a decrease leading to lower yields and impacting the overall returns of the fund.

Liquid funds are ideal for people who have idle cash and are looking for short-term investments which generate higher return than a typical savings account. These funds can be used to funnel money into equity funds through a systematic transfer plan (STP). STP offers a two-pronged benefit; first, it earns some returns on the money parked in the liquid fund and second, it helps average down the cost of investment in equity, thereby reducing risk related to equity investments. Further, investors who have received windfall gains or come into a large amount of money, but are undecided about where to invest it, can also use liquid funds to park funds for the short-term.

Liquid funds are classified as debt funds. Liquid fund returns are subject to capital gains tax, which is calculated on the basis of holding period.

The STCG tax impact can be reduced if you are in the highest tax bracket of 30% by opting for dividend reinvestment. In this situation, dividends are declared, but reinvested back into the fund. This results in lowering the capital gains while the reinvested dividends are considered as 'fresh investments'. However, for longer-duration investments, you should opt for growth option as you will get indexation benefits.

Liquid mutual funds have versatile uses; they can act as an alternative for savings accounts or be used to park funds that are yet to be invested or can even be used to create an emergency fund. These funds have a place in almost every investor's mutual fund portfolio.