What are Liquid Funds - Risk, Returns, and Benefits

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There are several reasons why people invest their money into various avenues: while some investors strive for capital appreciation in the long run, some target short term gains. While some investors value profitability even at the expense of high risk, others prefer stability and lower exposure to risk. One of the popular investment options that are renowned for their liquidity and relative stability is liquid funds. 

In this article, we shall delve into 

  • What are liquid funds 
  • How do liquid funds work 
  • Risk and returns on liquid funds 
  • Key advantages of liquid funds 
  • How to choose a liquid fund for your investment portfolio 

What are liquid funds?

Liquid funds are mutual funds that invest in a wide array of debt securities for a short duration. Some of the debt instruments that liquid funds invest in are government bonds, certificates of deposits, and treasury bills. Liquid mutual funds carry a maturity period not exceeding 91 days, and are targeted at the protection of the principal investment. The returns on liquid funds depend on the securities that constitute the fund; however, since such funds invest in high quality debt instruments, the returns are relatively stable. 

How do liquid funds work?

Liquid funds work just like any other mutual fund, with the only difference being their construct. As per the guidelines issued by the Securities and Exchange Board of India (SEBI), liquid funds must invest at least a fifth of their total corpus into liquid instruments, that is, cash and money market instruments). Another key SEBI guideline applicable to liquid mutual funds is that they cannot invest more than 20% in any particular sector. Although most of the returns on liquid funds are generated from the interest income from the underlying securities, there is scope for capital appreciation. 

Risk and returns on liquid funds

Liquid funds invest in short-term securities (with a maturity less than 91 days). As such, they are relatively less exposed to the impact of interest rate movements. Furthermore, since liquid funds can only invest a maximum 20% of their corpus into one sector, the overall risk is diversified. The securities that liquid funds invest in are usually credible debt securities issued by the government or listed companies, which makes such funds low risk investment options. 

With regard to the return on liquid funds, most of the income is interest income from the debt securities, and the rest is from potential appreciation in the market value. Although investments in liquid mutual funds may generate capital appreciation, the main target of such funds is to protect the principal investment. 

Key advantages of liquid funds

There are several reasons why liquid fund investment is considered an effective and low-risk choice. Here are the major advantages of liquid funds:

  • Low cost of investment: Since liquid funds are usually passively managed, they tend to have typically low expense ratios.
  • High liquidity: It is easy to redeem your investment in a liquid mutual fund, and the process usually takes a single working day.
  • Low risk: Liquid funds are characterised by their low risk exposure, owing to investment in highly credible and listed debt securities. 
  • Moderate but stable income: The return on liquid funds is generally moderate but stable. There is very little interest rate risk involved in such investments. 

How to select a liquid fund for your investment portfolio

Liquid funds are ideal investment options if you are looking for low risk, short-term investment vehicles. Since there is no dearth of liquid funds in the market, it is pivotal to choose the right fund for your investment portfolio. Here are some key factors you must consider to select a liquid fund that is in line with your investment goals. 

  • Past returns: You can check the past performance of various liquid funds and assess the one-month and three-month returns on each. Although past performance does not necessarily have any bearing on a fund's future performance, it can help you identify patterns, if any. 
  • Size of the fund: It is prudent to invest in liquid funds with a large fund size so that there is no significant impact of sudden redemption by institutional investors.
  • The diverse, the better: Investments in liquid funds can be a great way to diversify your investment portfolio. It is, therefore, crucial to check the assets that constitute the allocation of a liquid mutual fund fund before you select any fund.
  • Cost of investment: Another key aspect of investments in liquid funds is their cost. Ideally, the expense ratio of a liquid fund should be quite low. Since the expense ratio of a mutual fund affects your net returns from the investment, the lower the ratio, the better. 

To sum it up

Liquid funds entail a wide array of advantages for investors, including low risk, high liquidity, stable returns, and a significant degree of diversification. You can assess and compare various liquid mutual funds and decide which one is the right fit for your investment portfolio.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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