Liquid funds are a preferred option among investors seeking to create an emergency corpus. Read this article to find out what liquid funds are and the many benefits associated with this investment avenue.
Financial experts often encourage investors to set aside at least three months of expenses in an emergency fund. After all, the events in one's life may not always go as planned. The individual could lose his or her job, have a medical emergency, or the economy could head to another recession. Without any form of financial preparation, such scenarios could leave the individual devastated and stressed both mentally and financially. This is why it is essential to set up a contingency fund. The investment route that is typically recommended is the one that provides the combined benefit of capital safety with easy liquidity. Liquid funds are a popular investment channel that meet these criteria.
What are Liquid Funds?
Liquid funds are a kind of mutual funds where money is put into in securities whose residual maturity is up to 91 days. They belong to the debt category of mutual funds, and invest in very short-term market instruments, such as government securities, treasury bills and call money. Liquid funds are becoming popular with retail investors on account of easy liquidity and the fact that their returns are greater than savings bank account. On submitting a redemption request, the investor will be able to get the money back within 24 hours.
These funds have the lowest interest risk as compared to the other classes of debt funds. They predominantly park money in fixed income securities that have a short maturity. Investors who are seeking to create an emergency fund must definitely consider investing in liquid funds. The returns they can receive are higher, and the money can be taken out quickly in the event of emergencies.
- Return efficiency: Investors typically begin to earn returns from the date of investment, thus minimizing any return leakage.
- Minimal capital risk: Liquid funds are highly rated, which means there is minimum loss from credit defaults. The scheme parks money in instruments with a maturity profile of 91 days or less. The very short maturity period helps minimize the mark-to-market volatility in the portfolio, thereby reducing capital risk.
- Flexibility: Investors are given the flexibility of investment options like growth and dividend pay-out with weekly or monthly frequencies. The money can be transferred to equity funds as and when they feel the valuations seem right.
Factors To Consider Before Investing In Liquid Funds
Here are some important elements that must be taken into account before investing in liquid funds:
- Risks : Given that the underlying assets mature within 91 days, the NAV does not experience much fluctuation. It remains almost steady. This makes such funds a low-risk investment. However, it is essential to note that if the credit rating of any underlying security falls, the NAV can witness a drop as well. Liquid funds are not entirely risk-free.
- Returns : Historically, liquid funds have generated returns in the range of 7-9% on an average. They are better than the returns earned on savings account deposits. While the returns (of liquid funds) are not guaranteed, they have mostly delivered positive returns upon redemption.
- Investment Plan : Many investors prefer liquid funds to create an emergency corpus. Their returns are reasonable and the risks involved are low. The funds are best-suited for investors with a 3-month investment horizon. Prior to investing, individuals must ensure to have an investment plan accordingly.
- Expense Ratio: Similar to the other mutual fund schemes, liquid funds also levy an annual fee for providing fund management services. This is referred to as expense ratio – a percentage of the total assets of the fund. Most debt investors prefer funds with a lower expense ratio as it helps to maximize their gains.
Additionally, most fund managers invest and hold the security till the time of maturity. Thus, the fund does not incur expenses on account of excessive buying and selling of securities - which keeps the expense ratio low.
For taxation purpose, liquid funds are treated similar to other debt funds. If it is held for less than 3 years, then it shall be considered as Short-Term Capital Gain (STCG). However, if the investor holds for over 3 years, then it is regarded as Long-Term Capital Gain (LTCG). The tax treatment is different for growth and dividend plans. Investors are not taxed for dividends received under liquid plans, but fund houses are required to pay dividend distribution tax.
Through liquid funds, investors can gain from risk adjusted returns, accessibility and safety while maintaining a contingency fund. Thus, it would be wise to put money into such funds and begin an SIP for the purpose of setting up a contingency fund.