Many times, we have some idle money left in our banks which cannot be used immediately. If we continue to keep this money in our saving accounts, you will not get good returns from it and you will also miss the opportunity of investing this money somewhere else. Now the question is where to invest this money so that we can get decent returns along with less risk. This is where the liquid mutual funds are considered. But before considering investing in liquid funds, following things should be kept in mind:

1. The money is parked for a short period of time and has no immediate use.
2. The period for which the money is parked is not fixed.
3. The safety is more important than getting good returns.

In the above conditions are met, we can consider liquid funds to invest our money there. One may ask that fixed deposit can also serve the purpose then why to choose liquid funds in this case. There is a big difference in FD and liquid funds and that is flexibility. Fixed deposits are invested for a fixed period and hence there is no flexibility in terms of time of investment. It is not the case with the liquid funds. You can withdraw your idle money can be invested in liquid funds any time and these funds give decent return also.

What are Liquid Mutual Funds?

Liquid mutual funds are the debt funds which invest in fixed- income instruments like government securities, treasury bills, etc. These instruments have a maturity period of up to 91 days. These funds carry the lowest interest-rate risk in the debt funds category. 

Objective of Liquid Mutual Funds

The main objective of liquid mutual funds is to provide liquidity and security to the investors. Therefore, the fund manager invests your money in high quality debt securities and makes sure that the average maturity period of the fund is not more than 91 days. It serves both the purpose of providing the investor liquidity along with security of money. Liquid funds offer better returns as compared to saving bank accounts.

Money Market Instruments where the Liquid Funds Are Invested

There are various money market instruments where the liquid funds are invested, some of which are as follows:

Certificate of Deposit (CD)

These are term deposits, very similar to fixed deposits. These are offered by scheduled commercial banks. The only difference between FD and CD is that you cannot withdraw CD before the expiry of the term. 

Commercial Paper (CP)

Commercial papers are issued by companies and other financial institutions that have a high credit rating. Also known as promissory notes, commercial papers are unsecured instruments issued at the discounted rate and redeemed at face value. The difference is the return earned by the investor.

Treasury Bills (T- Bills)

T-bills are issued by the Government of India to raise money for a short term of up to 365 days. These are the safe instruments as the sovereign guarantees back them. The rate of return in treasury bills is less as compared to other type of instruments. This rate of return is also called as risk-free return.

Are Liquid Funds Suitable for You?

If you have a good sum of money laying idle in your bank accounts and you are looking for a short duration investment with minimum risk, then you may consider liquid funds for this purpose. Many investors consider liquid funds as a stepping stone for investing in equity funds. They first accumulate sufficient amount in their liquid funds and then systematically invest that money in equity funds to achieve their long term financial goals.

Factors to Be Considered Before Investing in Liquid Funds

Risk

Liquid fund are not completely risk free. If the credit rating of any security incorporated in the liquid fund drops then the NAV of the liquid fund drops too. However, since the maturity period of liquid funds is not more than 91 days, liquid funds do not experience a lot of volatility.

Investment Horizon

You should check whether the maturity period of liquid funds matches your requirement or not. If you are looking for a very short investment horizon and the maturity period of liquid fund is more than that then you should not consider that liquid fund for investment. Liquid funds are ideal if your investment horizon is up to three months. In case you have a longer investment horizon, say of up to one year, then you may consider investing in ultra-short-term funds to get relatively higher returns. 

Expense Ratio

Expense ratio is also an important factor which should be considered before investing in a particular liquid fund. Like other mutual funds, liquid funds also charge a nominal amount from the investor as expense ratio. The expense ratio is a percentage of total assets of the fund. The funds with the low expense ratio are preferred by the investors since it maximize their gains. SEBI has mandated the upper limit of expense ratio to be 1.05%.

Rate of Return

Past performance of the funds will give you an idea about how much returns a liquid fund can provide. Normally the liquid funds offer around 7 to 9% of the returns which is always better than 4% return the saving accounts offer.

Tax on Gains

Liquid funds are debt funds and when you invest in liquid funds, you earn capital gains. Capital gains are taxable. Capital gains made in the first three years of investment is called short term capital gain (STCG) and the capital gain made after three years is called long term capital gain (LTCG). Short term capital gains are added to your income and taxed according to your income tax slab rate while the long term capital gains are taxed at a flat rate of 20% after indexation. Another type of income is the dividend income offered by the liquid funds which is added to your income and taxed according to your income tax slab rate.

Financial Goal

Before investing in a liquid fund should be clear about your financial goals. Liquid funds are best for creating emergency funds. You can use them as a stepping stone for investment in equity market also. Your objective for investing in the liquid funds should be clear and should make your investment strategy accordingly. Sometimes if you have some idle money laying at your banks, you can invest it in liquid funds to gain better returns.

Top Five Liquid Funds in India

Top five liquid funds based on the past annual rate of returns are given in the following table:

Conclusion

Liquid mutual funds are ideal when you have a good amount of money laying in your bank accounts which is of no immediate use and you can invest this money minimum up to 91 days. Good liquid funds can give you 7 to 9% returns which is much better the 4% return the saving banks offer. Liquid funds are better the ‘fixed deposits’ in terms of liquidity as they provide you flexibility to liquidate in a short period.

Also read: Investing in Fund of Funds (FOFs)