What are Liquid Funds

What is a Liquid Fund?

Liquid funds, often referred to as liquid mutual funds, are a type of debt fund that invests in short-term debt instruments. These instruments typically have a maturity of less than 91 days. Investors are drawn to liquid funds because they offer a safe and stable place to park money temporarily, with the flexibility to redeem the funds quickly. 

Since these funds focus on short-term debt, they generally offer better returns than a traditional savings account while maintaining a low level of risk.

Key Features of Liquid Funds

We have mentioned a few key features of Liquid mutual funds that make them attractive to conservative investors looking for stability and liquidity, such as —

• No Entry or Exit Load: These funds allow investors to buy and sell without incurring additional charges
• Flexible Minimum Investment: The minimum investment amount varies for each liquid fund, offering flexibility for different types of investors
• Low Interest Rate Risk: Because liquid funds invest in short-term debt, they are less affected by fluctuations in interest rates
• Quick Redemption: Investors can redeem their investments quickly, usually within 24 hours, ensuring high liquidity

How Do Liquid Funds Work?

Debt liquid funds operate by pooling money from multiple investors and investing it in short-term debt instruments that are considered low-risk. The fund manager ensures that the portfolio maintains a short average maturity and invests in highly liquid debt securities. 

Where do Liquid Funds Invest?

The Best liquid funds are designed to minimise exposure to risk while providing the necessary liquidity.

These funds must hold at least 20% of their assets in cash or cash equivalents, ensuring they can meet redemption demands quickly.

Liquid funds invest in —

• Government Securities: Bonds issued by the government with short-term maturity
• Treasury Bills: Short-term securities issued by the government to meet its short-term financial needs
• Commercial Paper: A form of unsecured, short-term debt issued by corporations
• Certificates of Deposit: A type of short-term investment issued by banks with fixed interest rates

Sources of Earnings:

Liquid mutual funds earn primarily through interest payments from their debt holdings. Since these funds primarily invest in short-term securities, they are less sensitive to changes in interest rates compared to long-term debt instruments. 

This means that liquid funds generally offer stable returns, making them ideal for short-term parking of funds.

Who Should Invest in Liquid Funds?

Liquid funds are best suited for individuals who have idle cash and are looking for a safe, low-risk investment option that offers better returns than traditional savings accounts.
Some ideal investors include —

1. Short-Term Investors: Investors with short-term goals or those looking for low-risk investments with quick access to funds.
2. Emergency Fund Builders: Individuals who want to set aside money for emergencies while earning some returns.
3. Cash Reserve Holders: Those with surplus cash they don’t need immediately can benefit from investing in liquid funds.
4. Investors Transitioning to Equities: Those looking to invest in equity funds but want to park their money temporarily can use liquid funds as a stepping stone.

Benefits of Liquid Funds

Liquid funds offer numerous advantages, particularly for investors looking for stability, liquidity, and modest returns —

• High Liquidity: One of the biggest advantages of liquid funds is their high liquidity. This means that investors can easily convert their investment into cash without significant delays or losses.
• No Major Losses on Withdrawal: Since liquid funds invest in short-term, high-quality debt instruments, the value of the investment typically remains stable, even if you need to redeem it quickly.
• Capital Preservation: The primary goal of liquid funds is to protect your principal investment while providing modest returns. This makes them a safe option for conservative investors who prioritise the security of their investment over higher returns.
• Short-term Investments: By focusing on short-term debt securities (usually with maturities up to 91 days), liquid funds are less sensitive to market changes, making them more stable during periods of economic uncertainty.
• Better than Savings Accounts: In a typical savings account, interest rates are low and subject to change based on central bank policies. On the other hand, liquid funds usually offer higher returns due to their investment in short-term, market-linked debt instruments.
• Attractive During Inflationary Periods: When inflation is high, the returns on savings accounts may not keep up with the rising cost of living. However, liquid funds can provide steady returns that slightly outpace inflation, offering a better alternative for parking funds temporarily.
• Low Expense Ratios: Most liquid funds have a low expense ratio (often below 1%), meaning a smaller portion of your returns goes towards management fees. This helps to maximize your potential returns.
• Minimal Active Management: Since liquid funds invest in short-term, highly liquid instruments, they require less active management than other funds that invest in long-term assets, reducing operational costs.

Top 10 Best Liquid Mutual Funds

Here are some of the best liquid funds for you to compare on the basis of 3-year annualised return and expense ratio —

Note: The above values can fluctuate, so it's a good idea to check them regularly to stay updated on their performance.

SIP Calculator

Factors to Consider Before Investing in Liquid Mutual Funds India

Before investing in Liquid Funds India, it's essential to understand the factors that will influence your decision. 

These factors ensure that the investment is aligned with your financial needs and goals. 

1. Investment Horizon

Liquid Funds are ideal for short-term goals (few days to months). If you need a secure place to hold your funds temporarily, these funds are an excellent choice. They are perfect for emergency funds, short-term savings, or temporary parking of surplus funds that you don’t want to invest in riskier assets.

2. Risk Tolerance

They are safer compared to other funds like equity or balanced funds since they invest in high-quality, short-term debt instruments. However, no investment is completely free of risk, and even though the risk is low, it’s crucial to ensure that you are comfortable with the nature of the fund.

If you have a low risk tolerance, Liquid Funds are a good choice. However, if you’re willing to take on more risk for potentially higher returns, other mutual fund options might better suit your needs. 

3. Financial Goals

Liquid Funds are suited for short-term goals (emergency fund, temporary savings). However, for long-term financial goals (such as retirement or saving for a child's higher education), Liquid Funds might not provide the high returns needed. In such cases, equity funds or hybrid funds that offer higher returns over time would be a better option.

4. Liquidity Needs

Debt Liquid Funds offer high liquidity, with 24-hour redemption. This makes them a great choice for investors who need to access their money on short notice. However, if you need instant access or are looking for long-term growth, other options may be better suited.

5. Safety of Investments

While Liquid Funds are considered safe investments, it’s important to evaluate the credit quality of the debt instruments in the fund's portfolio. You should also assess the fund manager's track record and the overall management of the fund to ensure that the safety of the fund's assets aligns with your comfort level.

6. Potential Returns

Liquid Funds are designed to offer stable but modest returns. They are primarily generated through the interest earned on the short-term debt instruments in which they invest.

Although returns may be lower than equity funds, they are generally stable and predictable, making them ideal for short-term parking of funds. Before investing, make sure the potential returns align with your financial objectives and expectations.

7. Expense Ratio

Liquid Funds are generally known for having low expense ratios (usually less than 1%), which means more of your returns stay with you. When comparing different Liquid Funds, choose one with a lower expense ratio to help you maximise your returns over time.

Taxation Rules of Liquid Mutual Funds

Here’s how taxes are applied to the income generated from Liquid Funds in India —

1. Short-Term Capital Gains Tax (STCG)

When you redeem Liquid Fund units within 3 years of investment, the profits are classified as short-term capital gains. These gains are taxed at your applicable income tax slab rate. 

2. Long-Term Capital Gains Tax (LTCG)

If you hold your Liquid Fund units for more than 3 years, the gains are considered long-term capital gains. Long-term capital gains (LTCG) are taxed at a flat 20%. Additionally, the benefit of indexation also applies, which allows you to adjust the purchase price of the investment based on inflation, reducing your taxable gain and, consequently, your tax liability.

3. Tax-Free Dividend Income

Dividends paid, declared, or distributed on or after April 1, 2020, are subject to Tax Deducted at Source (TDS) under Section 194 of the Income Tax Act.

• For Resident Shareholders:
  • A TDS of 10% is deducted on the dividends paid if the total dividend amount exceeds Rs. 5,000 during the financial year
  • The TDS is deducted based on the shareholder's PAN
  • If the dividend amount is Rs. 5,000 or less, no TDS is deducted
     
• For Non-Resident Indians (NRIs):
  • TDS is deducted at the rate of 20% on dividends paid to NRIs
  • The rate may vary according to the Double Taxation Avoidance Agreement (DTAA) between India and the NRI's country of residence

Frequently Asked Questions