What are Liquid Funds?

6 mins read
by Angel One
हिंदीગુજરાતીಕನ್ನಡதமிழ்తెలుగుमराठी
If you want to park excess funds for a short time except in your savings account, then liquid funds are the best option you have. These are short-term debt funds with a maximum maturity duration of 91 days, ideal for investors with excess investable funds. As the name suggests, these are highly liquid funds that would earn higher returns than your savings account. Let's understand liquid funds in detail and why these should be in your investment kitty.

Understanding liquid funds

Liquid funds are short-term investment schemes that invest in short-term, fixed-income generating investment options like Treasury bills, commercial papers, and the like. The primary purpose of the liquid funds is to offer liquidity, and hence, the investments in the fund have a maximum maturity period of 91 days. The allocated proportion meets the fund's objective. The fund manager ensures that the average maturity period of the scheme is three months. It reduces the sensitivity of the fund's returns due to changes in interest rates, making it less vulnerable. As a result, the fund's returns don't experience too many fluctuations and create a low-risk investment option for investors. Liquid funds are ideal for parking idle investable amounts - emulates the liquidity aspect of a bank's savings account but earns higher returns. Moreover, there is no lock-in period. Hence, investors can use liquid fund schemes instead of their savings accounts to make higher returns.

Types of money market securities

Liquid funds invest in the following money market instruments.

Certificate of deposit (CD)

These are fixed-term deposits issued by scheduled commercial banks. The only difference from the fixed deposit is, investors can't redeem certificates of deposits before maturity dates.

Commercial papers

These are promissory notes issued by large corporations with very high credit ratings. These are unsecured investments issued at discounted rates and redeemed on maturity. The difference between the two is the return earned by investors.

Treasury bills (T-bills)

these investment instruments are issued by the government of India to finance short-term needs with a maturity tenure of 365 days. These are risk-free investments backed by the sovereign and earn lower risk-free interest than other investment options.

Who should invest in Liquid Funds?

  • Investors with an idle investable amount looking for a haven can park their funds in liquid fund schemes
  • Investors with short-term investment goals
  • Investors need time to decide the right investment option, looking for a temporary but liquid investment for their fund
Liquid funds generate returns in performance-based incentives, bonuses, and other forms of gains from selling capital assets. You can initially invest the corpus in a liquid fund and then set a systematic transfer to an equity fund of your choice.

How Much Return Can You Expect From Liquid Funds?

Liquid funds typically invest in instruments with maturities of up to 91 days. These funds offer lower returns compared to debt funds like short-term funds, low-duration funds, and ultra-short-term funds.  On the other hand, liquid funds generally offer better returns than overnight funds, which primarily invest in overnight securities. Under normal circumstances, liquid funds are expected to yield higher returns than the interest rates offered by savings bank accounts. Historically, it has offered around 7-9% returns per year. Therefore, people often choose to use liquid funds to temporarily park their excess funds that would otherwise earn lower returns in a bank account.

How do I Invest in Liquid Funds?

Before you start investing in liquid funds, investors should complete their mutual fund KYC (Know Your Customer) process with their respective  You have two options for investing: 

Via Angel One

Step 1: Log in to your Angel One account using your registered mobile number. Verify the OTP and enter your MPIN. Note: If you don't have an Angel One Demat account, you can open one quickly by completing the KYC procedure and providing the necessary documents. Step 2: Choose the right fund for your needs and risk tolerance by considering these factors:
  • Search for your preferred fund or explore Angel One's recommended options.
  • Review the fund's historical performance, tax implications, sectors, and stocks it invests in.
  • Estimate potential returns using the calculator.
  • Assess the fund's risk level and match it with your risk tolerance.
  • Check the fund's ratings from reputable agencies (typically rated on a scale of 1 to 5).
  • Consider the fund's expense ratio to understand the cost of investing.
Step 3: Once you've decided on the fund(s) to invest in, access your Angel One account, navigate to the Mutual Funds section, and locate your chosen fund. Since this may be a long-term investment, be cautious when making your selection. At this stage, consider the following:
  • Decide between a lump sum investment or a monthly SIP.
  • Enter the investment amount and choose your preferred payment method (preferably UPI or net banking).
  • For SIP investments, set up a mandate for hassle-free future instalments.

Directly from the Asset Management Company (AMC) website

If you choose to go through a mutual fund distributor, you can choose between various funds and different investment plans all in one place. However, the AMC website provides only the funds offered by the asset management company (AMC). When it comes to liquid fund redemptions, the funds are usually credited to your bank account within one business day, known as T+1 day, where T represents the day of the transaction. Some AMCs also offer instant redemption of liquid funds through their mobile apps or mutual fund distributors, allowing you to receive the redemption proceeds in your bank account within a few minutes of making the request.

How do Liquid Funds Work?

Liquid funds operate by investing in short-term, high-quality, and easily tradable securities. Recent SEBI guidelines have reinforced these characteristics of liquid funds, focusing on safety and liquidity.  One key requirement for liquid funds is to maintain at least 20% of their assets in highly liquid instruments, like cash or money market securities. This liquidity ensures they can promptly meet redemption requests from investors. These funds also have sector exposure limits of up to 25%, to minimise credit risk. The primary source of earnings for liquid funds is the interest payments they receive from their debt holdings. Capital gains make up only a small portion of their income. This unique feature sets liquid funds apart from other investment options. Here's how they benefit from this structure:
  1. When interest rates in the market decrease, the prices of bonds rise. 
  2. Conversely, when interest rates increase, bond prices fall. 
This relationship is more pronounced in long-term bonds, meaning they are more sensitive to market yield changes. However, liquid funds exclusively invest in short-term securities. Consequently, their market value does not fluctuate significantly when market interest rates change. This characteristic results in liquid funds having minimal capital gains or losses. In an environment with rising interest rates, liquid funds often outperform other debt funds because:
  1. Their interest earnings increase, and 
  2. Their market values are only mildly affected by capital losses. 
In financial terms, liquid funds are said to have very low interest rate risk, making them a suitable option for investors seeking stability and liquidity in their investments.

Advantages of Liquid Funds

Liquid funds have several benefits for investors, such as:
  • Low Risk: Liquid funds prioritise capital safety and provide stability during interest rate fluctuations, making them a low-risk choice.
  • Steady Returns: Liquid funds aim for stable returns, making them suitable for short-term financial goals.
  • Diversification: They offer diversification by investing in a mix of debt instruments, spreading risk.
  • Low Cost: These funds are cost-effective due to minimal active management, with expense ratios often below 1%.
  • Flexible Holding: Investors can hold their money for as long as needed, with easy entry and exit options.
  • Quick Redemption: Liquid funds process redemptions swiftly, typically within one working day, thanks to investments in highly liquid and low-risk securities.

How to Redeem Liquid Funds?

Redeeming liquid funds is a relatively straightforward process, and it typically involves the following steps:
  1. Access Your Angel One Account: To redeem your liquid fund units, you need to log in to your Angel One account via the online portal or the mobile app.
  2. Select the Fund: Once you've accessed your account, navigate to the section where you can view your mutual fund holdings. Locate the specific liquid fund you want to redeem from your portfolio.
  3. Specify the Amount: Choose the amount or number of units you want to redeem. Most platforms will allow you to enter either the specific amount you want to withdraw or the number of units you want to redeem.
  4. Redemption Method: Liquid funds typically offer two options for redemption, depending on the fund:
   - Instant Redemption: Some liquid funds provide the option of instant redemption, which allows you to receive the funds in your linked bank account within a few minutes. This is a convenient option if you need immediate access to your money.    - T+1 or T+2 Redemption: While with other funds, the redemption amount will be credited to your bank account within one or two business days (T+1 or T+2). This is a more common redemption process for most liquid funds.
  1. Bank Account Details: Ensure that your bank account details are correctly linked to your Angel One account. The redemption proceeds will be credited to this bank account.
  2. Review and Confirm: Double-check all the details you've entered, including the amount, fund name, and bank account information. Confirm your redemption request.
  3. Wait for Confirmation: After confirming the redemption request, you will receive a confirmation message or email. This confirmation will include the date on which the redemption proceeds will be credited to your bank account.
  4. Receive Funds: On the specified date (either T+1 or T+2, depending on the fund), the redemption amount will be credited to your linked bank account.
  5. Monitor Tax Implications: Be aware of the tax implications of your redemption. In many countries, gains from liquid funds are subject to capital gains tax. You may want to consult with a tax advisor for guidance on managing your tax liabilities.
Keep in mind that some liquid funds may have specific rules or restrictions, such as exit loads for withdrawals made within a certain time frame or minimum redemption amounts.  It's essential to review the fund's offer document or consult with your financial advisor if you have any questions or concerns about redeeming your liquid fund investments.

Taxation on Liquid Funds

Liquid funds provide investors with opportunities to earn dividends and capital gains. Dividend income from mutual funds is typically not subject to taxation. However, capital gains earned by investors when redeeming units of a liquid fund are taxable. After April 1, 2023, any returns or profits earned on debt funds are subject to the tax rate as per the individual's income tax slab. This tax is calculated for both short-term and long-term capital gains.

How to Find the Best Liquid Fund

To find the best liquid fund for your investment, consider the following criteria:
  1. Historical Returns: Liquid funds primarily invest in short-term debt with maturities of up to 91 days. To evaluate fund performance, look at 1- or 3-month returns. Longer-term returns (1 or 3 years) are not relevant for liquid funds. A good liquid fund should consistently outperform its benchmark and peers, as evidenced by short-term returns over the past few years.
  2. Expense Ratio: Since liquid funds typically invest in similar short-term debt securities, returns don't vary significantly among fund houses. Therefore, compare the expense ratios, which represent the annual management fees charged by the fund. Lower expense ratios result in higher net returns for investors.
  3. Portfolio Diversification: Liquid funds are favoured for their ability to preserve capital. It's important to review the fund's portfolio to ensure it includes a diverse range of securities from different issuers. This diversification helps minimise the impact of defaults by any single issuer.

Considerations before investing in liquid mutual funds

Investors interested in liquid funds must consider the following factors.
  1. Risk: In liquid funds, the associated risk is less. The peril with mutual fund investing concerns fluctuating NAV, but liquid funds invest for the short-term, and hence, the value doesn't get affected by changing rate of interest.
  2. Returns: Historically, liquid funds have earned 7 to 8 percent returns against 4 percent on the savings account. Although the returns from liquid funds are not guaranteed, they have generated positive returns.
  3. Cost: Compared to other investments, liquidity funds charge lower fees. It is called the expense ratio, and SEBI has fixed the upper limit for expense ratio at 1.05 percent of the investable amount.
  4. Investment horizon: Liquidity funds hold securities that have a maturity of no more than 91 days. These are suitable to park additional funds for a short period and thus enjoy the full potential of the underlying securities. For an investment horizon of one year or more, you can consider ultra-short-term funds.
  5. Financial goals: Liquid funds are a good option for creating emergency funds. These funds earn higher returns but don't have early cancellation penalties like FD and are readily available in emergencies. Usually, redeeming liquid funds takes one working day.
  6. Taxation: Capital gains tax applies to the returns earned from the investment, depending on investment duration. Since liquidity funds invest in debt instruments, gains made during the first three years is taxable under short-term capital gain. Beyond three years, long-term capital gain tax is applied.
For short-term gains, the tax rate applies per the income tax slab of the investor. Long-term gain is taxed at a flat rate of 20 percent after indexation. Similarly, dividends earned get added to the total income of the investor and taxed accordingly.

Conclusion

Because of high liquidity, liquid funds have become widely popular. Hence, you can now find the best liquid funds easily by searching them online. We hope this explainer has helped you understand liquid funds' meaning and make an informed investment choice.

FAQs

Are liquid funds better than FD?

Liquid funds and Fixed Deposits (FDs) serve different purposes. Liquid funds offer higher liquidity and potentially better returns in the short term compared to FDs. However, FDs are considered safer and provide fixed interest rates. The choice depends on your financial goals and risk tolerance.

Is it good to invest in liquid funds?

Investing in liquid funds can be a good option for short-term goals or parking surplus funds. They offer the potential for better returns than traditional savings accounts while maintaining high liquidity.

What is a liquid fund SIP?

Liquid fund SIP (Systematic Investment Plan) allows you to invest small, regular amounts in a liquid fund. It’s suitable for individuals looking to save or invest regularly while benefiting from the safety and liquidity of liquid funds.

Are liquid funds tax-free?

Liquid funds are not entirely tax-free. Dividends from liquid funds are tax-free in the hands of investors. Capital gains from redemptions are taxed at the investor’s income tax slab rate.

Do liquid funds require a demat account to invest?

No, liquid funds do not require a demat (depository) account to invest. They can be purchased directly from the fund house or through various financial platforms and brokers without the need for a demat account.

Are liquid funds safe?

Liquid funds are generally considered safe investment options. They primarily invest in low-risk debt instruments with short maturities, minimising interest rates and credit risk. 

However, like any investment, there is some degree of risk involved, albeit relatively low. It’s essential to research and select liquid funds from reputable fund houses and monitor their performance periodically.