What Is A Liquid Fund? Meaning, Types, Benefits And More!

7 mins read

Managing short-term funds efficiently is crucial for individuals and businesses alike. Many investors seek an option that offers better returns than a savings account while maintaining high liquidity and low risk.

Liquid funds serve this purpose by investing in short-term money market instruments that provide stability and quick access to funds. Whether you need a temporary parking space for surplus cash or a secure investment option for emergency funds, liquid funds offer a flexible and efficient solution.

This article explores liquid fund meaning and its features, benefits, risks, and suitability for investors. Let's dig in. 

What is Liquid Fund? 

A liquid fund is a type of mutual fund that primarily invests in short-term money market instruments such as treasury bills, commercial papers, certificates of deposit, and other short-duration debt securities. These funds are designed to provide investors with high liquidity, low risk, and relatively stable returns, making them an excellent option for parking surplus cash for short periods.

How Liquid Funds Work

Liquid funds invest in high-quality debt instruments with maturities of up to 91 days. Since these securities have short durations, they are less affected by interest rate fluctuations, making liquid funds a relatively stable investment option.

For example, if an investor places money in a liquid fund that invests in treasury bills and commercial papers, the fund earns returns based on the interest rates of these instruments. The investor can redeem their investment at any time, typically receiving the funds within one business day.

Features of Liquid Funds

1. Short Maturity Period: These funds invest in instruments with a maturity of up to 91 days, reducing risk and volatility.
2. High Liquidity: Investors can redeem their investments within 24 hours, making them suitable for emergency funds.
3. Low Volatility: As they invest in high-quality, short-term debt securities, they are less affected by market fluctuations.
4. No Exit Load (Beyond 7 Days): Many liquid funds do not charge exit loads after seven days, ensuring cost-effective withdrawals.
5. Stable Returns: While they do not offer high returns like equity funds, they provide better returns than a savings account or fixed deposits.

Types of Liquid Funds

1. Retail Liquid Funds

• Targeted at individual investors.
• Provide a secure and convenient option for short-term savings.
• Example: An investor looking for better returns than a savings account without risking capital can invest in a retail liquid fund.

2. Institutional Liquid Funds

• Cater to businesses and corporations needing liquidity for operational expenses.
• Often have a higher investment threshold.
• Example: A company temporarily holding cash before paying salaries can park the amount in an institutional liquid fund to earn short-term interest.

3. Ultra-Short Duration Funds (Similar to Liquid Funds but Longer Maturity)

• Invest in debt instruments with a maturity of 3 to 6 months.
• Slightly higher returns than liquid funds but with marginally higher risk.
• Example: An investor needing funds in six months for a major purchase can opt for an ultra-short duration fund instead of a savings account.

How to Invest in Liquid Funds?

For anyone wanting to invest in liquid funds, the key steps include: 

Step 1: Choose a Fund House

Compare different liquid funds based on returns, expense ratio, and risk rating.

Step 2: Decide on Investment Mode

Choose between lump sum investment (for large amounts) or Systematic Investment Plans (SIP) (for regular small investments).

Step 3: Monitor Fund Performance

While liquid funds are low-risk, checking for credit rating downgrades and tracking errors is essential.

Benefits of Investing in Liquid Funds

Liquid funds offer various advantages that make them ideal for investors. Here are a few benefits they offer: 

1. Better Returns than Savings Accounts

• Liquid funds generally offer higher interest rates than traditional savings accounts.
• Example: If a savings account provides 3% annual interest, a liquid fund might offer 4-6% annualized returns.

2. Quick Redemption and High Liquidity

• Investors can redeem their money within one business day.
• Example: If an investor needs urgent funds for an emergency, they can withdraw from a liquid fund and receive the money within 24 hours.

3. Low Risk and Capital Protection

• These funds invest in AAA-rated debt instruments, reducing default risk.
• Example: Unlike equity funds, where prices fluctuate daily, liquid funds remain stable as they invest in secure, short-term instruments.

4. No Long Lock-in Period

• Investors are not required to stay invested for years.
• Example: Unlike fixed deposits that may have a 5-year lock-in, liquid funds allow withdrawals anytime.

Risks Associated with Liquid Funds

1. Credit Risk

• If the issuer of the underlying security defaults, it could impact fund returns.
• Example: If a commercial paper in the portfolio defaults, it may lead to slight losses.

2. Interest Rate Risk

• If interest rates increase, existing debt securities may yield lower returns.
• Example: A rise in government bond rates may cause a minor decline in the liquid fund’s NAV.

3. Inflation Risk

• Liquid fund returns may not always outpace inflation.
• Example: If inflation is 7% and the liquid fund gives a 5% return, the investor’s real returns are negative.

Who Should Invest in Liquid Funds?

1. Investors Seeking a Parking Space for Surplus Cash

Liquid funds are ideal for those who have idle money but don’t want to keep it in a savings account where returns are lower.

Who can invest: If an investor receives a year-end bonus but doesn’t need it immediately, they can invest in a liquid fund until required.

2. Emergency Fund Investors

Those looking for a safe and liquid investment for emergency funds can consider liquid funds.

Who can invest: A person who wants quick access to emergency cash without sacrificing returns can use liquid funds instead of a savings account.

3. Businesses Looking for Short-Term Investments

Businesses with surplus cash waiting for deployment can earn short-term returns through liquid funds.

Who can invest: A company expecting to pay taxes in three months can invest the amount in a liquid fund to earn interest before making the payment.

4. First-Time Mutual Fund Investors

Investors who are hesitant about stock market volatility can start with liquid funds before moving to equity investments.

Who can invest: A new investor looking for a low-risk investment option before exploring equity mutual funds can begin with liquid funds.

Conclusion

Liquid funds are an ideal option for investors looking for a low-risk, high-liquidity investment for short-term financial goals. They offer better returns than savings accounts, ensure quick access to funds, and provide stability against market fluctuations. So, whether you are an individual with surplus cash or a business managing short-term liquidity, liquid funds can be a valuable addition to your financial strategy.

Quiz Time!!!

Frequently Asked Questions

1. Are liquid funds better than fixed deposits?

Liquid funds offer higher liquidity and competitive returns compared to short-term fixed deposits.

2. Can I withdraw money from a liquid fund instantly?

Some liquid funds offer instant redemption up to a certain limit, while others process withdrawals within 24 hours.

3. Are liquid funds taxable?

Yes, returns from liquid funds are subject to capital gains tax, depending on the investment duration.

4. Do liquid funds have any lock-in period?

No, liquid funds do not have a lock-in period, but withdrawals within seven days may attract a nominal exit load.

5. Are liquid funds safe during market downturns?

Yes, since they invest in short-term debt securities, they are less affected by stock market volatility.

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