What Are Liquid Funds And How To Choose Them | Motilal Oswal Mutual Fund (2024)

If there is one thing constant about the capital markets, it’s that they are always changing. Markets can fluctuate wildly in a matter of minutes. Fortunes can be made and lost within days. Investment opportunities, too, have become increasingly diverse and complex.

In the midst of these turbulent waters, liquid funds have come out as a relatively lower risk option compared to its counter parts, to park short-term funds. This is mainly because they offer comparatively lower risk and liquidity in equal spades.

In this blog, we will explore the meaning and workings of liquid funds, discuss the parameters to evaluate them, provide insights on how to choose the right liquid fund to invest in and highlight some top liquid fund returns in 2023.

Keep reading for more!

What is a liquid fund?

To begin with, let’s establish a clear understanding of what liquid funds are and how they function. Liquid fundsare a category of mutual funds that invest in highly liquid, low-risk debt instruments.

What does this mean?

In simple words, they are a type of debt mutual fund that keeps the fund portfolio in a variety of short-term fixed-income instruments that mature within a maximum of 91 days. These instruments can include Treasury Bills, Commercial Papers, Certificates of Deposit, and high-quality short-term debt securities issued by government entities, banks, and corporations.

These funds are specifically crafted to provide investors with a relatively lower risk and convenient investment avenue. They offer a secure and reliable option for parking surplus cash for short periods, while still allowing investors to earn modest returns. They’ve become particularly popular among corporates looking to park surplus funds for short durations, whether it be a few days or a few months.

As per data published by AMFI, corporates contributed to over 79% of the assets in the liquid fund, money market fund and floater funds category in the quarter ending March 2023.

What is a liquid fund?

Normally, we tend to approach mutual fund investments with a medium to long-term investment horizon in mind. After all, if you’re looking to invest in equity mutual funds, it is recommended that you stay invested for at least 8-10 years.

That’s only logical if you think about it. The stock market takes quite a topsy-turvy route to reach its targets. There can be sudden rises and falls that can impact the value of your equity investment.

With liquid funds, however, you can invest for even a few days!

Liquid funds aim to generate stable returns while maintaining liquidity and capital preservation. This sounds like quite a dream, right? How do these liquid fund returns work?

Liquid funds achieve this stability by investing in debt instruments with short maturities, ensuring that the underlying securities can be easily converted into cash without a significant impact on the fund’s net asset value (NAV).

Apart from that, liquid funds follow a mark-to-market valuation, where the NAV is calculated based on the prevailing market prices of the underlying securities. This ensures that the fund reflects the current value of its portfolio accurately.

The advantage of short-term instruments is that there is very low credit and interest rate risk. If the maturity period is a matter of days, the chances of major fluctuations are quite low. Add to that the fact that these are high-quality debt instruments from quality issuers like state and central governments.

Plus, unlike equity mutual funds, liquid fund returns are primarily generated through interest income. As the investments are in debt or fixed-income instruments, the rapid price action that we see in the stock market is notably absent here.

What parameters should you use to evaluate liquid funds?

Now that we have explained the liquid funds meaning and how it works, let’s move on to how you can select the right liquid fund to invest in.

The trick here is to remember the fact that liquid funds invest in a completely different asset class as compared to equity funds. They’re like apples and oranges; they cannot be compared and have to be evaluated on a different set of parameters.

When evaluating liquid funds, you can consider the following parameters.

1. Returns

You should remember that risk and return generally go hand in hand, especially when it comes to the capital markets. This means risky investments have higher pay-offs in comparison to relatively safer investments. Considering the fact that liquid funds are quite safe and stable, it comes as no surprise that the returns are on the lower side.

You should still assess the historical performance of the different schemes. Look for funds that have consistently delivered competitive returns in line with their peers and benchmark over different time periods.

2. Expense ratio

The expense ratio represents the annual fees charged by the fund house for managing the fund. This includes everything ranging from management fees to administrative and marketing expenses. It is expressed as a percentage in terms of your total investment amount.

If the expense ratio is 1%, for instance, this means 1% of the amount you have invested is going to be charged as the fee.

Lower expense ratios are generally favourable as they can have a positive impact on your overall returns.

However, please keep in mind that this is an investment and not a bargain deal you are shopping for. The cheapest option is not necessarily the best option. Don’t use this parameter as the sole basis of judgement. Instead, try to strike a balance between expenses and the quality of fund management.

3. Fund size and liquidity

Consider the size of the fund and its liquidity. Larger funds can offer better economies of scale and higher liquidity, thus enabling easier redemption.

4. Credit quality

When it comes to debt instruments, it’s all about the issuer. Just like lenders use your credit score to judge your trustworthiness when it comes to taking a loan, investors should judge the creditworthiness of the debt instrument on the basis of the issuer.

If the issuer is the government of India, for instance, you can rest assured that generally there will be no default.

But, if the issuer is a company you have never heard of, perhaps it is not prudent to jump in headfirst.

Evaluate the credit quality of the underlying securities held by the fund. Look for funds that predominantly invest in high-quality debt instruments issued by reputable and creditworthy entities.

5. Fund manager’s track record

The fund manager is the most important person in this regard. He/She is the one who takes judgement calls and optimises the allocation of the portfolio.

Assess the expertise and track record of the fund manager. A skilled and experienced fund manager can make informed investment decisions, adapt to changing market conditions, and navigate risks effectively.

How should you choose a liquid fund to invest in?

When it comes to choosing a liquid fund to invest in, doing market research to shortlist some schemes is the first step. The second step is more introspective in nature — it involves defining your own investment goals and strategies.

Building your investment portfolio is a very personal process; you should take the time to figure out your exact requirements before getting started. When choosing a liquid fund to invest in, you can consider the following steps.

1. Define your investment objectives

This is the first step. Determine your investment goals, time horizon and liquidity requirements. Understanding your financial needs will help you select a liquid fund that aligns with your investment objectives.

This may seem like quite an obvious task, but it isn’t. Unless you define your investment objectives, how will you judge the performance?

For example, if you’re looking for stability and gradual long-term growth, an aggressive fund is probably not the right option for you.

2. Assess the fund’s investment strategy

It is very important to understand the investment strategy of the fund. This is because you don’t really get to speak to the fund manager and understand their perspective. The strategy that the fund outlines is one of the best ways to check whether you’re on the same page.

Look for funds that maintain a well-diversified portfolio of high-quality debt instruments. You can consider the average maturity and duration of the portfolio, as it can impact the fund’s sensitivity to interest rate fluctuations.

3. Research and compare funds

Conduct thorough research on different liquid funds available in the market. Compare their past returns, expense ratios, portfolio and fund manager. You should refer to reliable sources such as fund fact sheets, annual reports and research platforms to gather relevant information and insights.

It may be tempting to simply mirror what your friends or peers are doing, but that is not an advisable course of action. Everyone’s investment requirements are different. Just because a particular liquid fund scheme is right for someone does not mean it will be right for you.

4. Analyse the risk-return profile

Now, we have already established that liquid fund returns are not as high as those of equity funds and the risk exposure is also significantly lower. Having said that, you can still choose between a liquid fund that has a more aggressive mindset versus one that does not.

To assess the potential stability of liquid funds, it’s important to evaluate their risk-return profile. Analyse their past performance across various market cycles and economic conditions. By considering how these funds have historically performed, investors can gain insights into their future stability.

This means when the market falls, liquid funds should hold strong. After all, when there is a bloodbath in the equity markets, investors will look for the safe haven that liquid funds can provide.

Look for funds that have demonstrated stability, consistency and competitive returns while managing risk effectively.

5. Consider tax efficiency

Earlier, liquid funds were taxed based on the holding period. Short-term capital gains tax applied if the investment was held for less than three years, while long-term capital gains tax applied if the investment was held for three years or more.

The short-term capital gains were added to your income slab and taxed accordingly. As for long-term capital gains, those were taxed at 20% after indexation.

Conclusion

Liquid funds have emerged as the fund type of choice for investors who prefer liquidity. It’s the ideal short-term parking zone for your funds. And with the rapid developments in the Indian mutual fund industry, you have a lot of different liquid mutual funds to choose from.

Remember, the key to successful investments lies in the prep work. Taking the time out to define your exact requirements and shortlisting the appropriate liquid fund schemes that align with your goals is definitely worth it.

Disclaimer: This blog has been issued on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this document is for general purposes only and not a complete disclosure of every material fact. The information/data herein alone is not sufficient and shouldn’t be used for the development or implementation of an investment strategy. It should not be construed as investment advice to any party. All opinions, figures, estimates and data included in this blog are as on date. The blog does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on our current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Readers shall be fully responsible/liable for any decision taken on the basis of this article.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.