Most households have idle money lying in their savings bank account. Depending on your income levels, the amount of balance in your savings bank accounts may vary, but money lying idle in savings bank is not productive because it earns very little income. Most banks pay 3.5 - 4% interest per annum on savings bank balances. If you factor in inflation (December 2018 – December 2017 CPI Inflation was 5.2%), then real returns on your savings bank balances are negative. Liquid funds on the other hand, are much better options for parking your surplus funds, because they give much higher returns compared to savings bank interest. In 2018, liquid funds on average gave 6.7% returns beating both savings bank interest and CPI inflation.
Most investors cite convenience and liquidity above returns as the reasons for keeping money in their savings bank account. While savings bank does provide convenience and liquidity, investors should be aware that liquid funds also provide very high liquidity and many convenient facilities.
In this blog post, we will try to dispel some common investor misconceptions about liquid funds and impress upon you, why you should park your surplus money, which you may require in the near term, in liquid funds.
What are liquid funds?
Liquid funds are debt mutual fund schemes which invest in Money Market instruments (including cash, reverse repo and debt instruments with maturity up to 91 days). These instruments include commercial papers, certificates of deposits, treasury bills etc. Since liquid funds invest in very short term securities, interest rate risk is very low and therefore, these funds assure high degree of safety. Liquid funds usually provide relatively higher accrual income. There is no lock-in period or exit load in liquid funds. This means that you can redeem your investment partially or fully, at any time without any penalty. Liquid funds like other mutual fund schemes, do not assure capital protection or fixed returns, but as mentioned earlier, they are among the safest mutual fund investments.
Misconceptions versus reality
Misconception 1: Liquid funds like other mutual funds are risky – they rise or fall with the market. The misconception is shaped by the perception that mutual funds only invest in stock markets.
Reality: There are different kinds of capital market instruments with very different risk profiles e.g. stock market, debt market, money market etc. Money market is the least risky compared to other capital market instruments. In any fixed income security, there are two kinds of risk – interest rate risk and credit risk.
Interest rate risk depends upon the maturity / duration of the security – longer the maturity, higher is the interest rate risk. Since liquid funds invest in securities which have residual maturities of less than 91 days, the interest rate risk is very low. Liquid funds typically have much lower credit risk, compared to other debt fund categories due to the very short term maturity profiles of their underlying securities. Historically impact of defaults has been much less on liquid funds compared to other debt fund categories, but nevertheless, you should invest in liquid funds of high credit quality. In summary, liquid funds are among the safest mutual fund investments - in the past 10 years, there has been only 1 week, when liquid fund returns were negative.
Misconception 2: You can draw money from your savings bank account at any time (using ATM card or your cheque book). It takes much longer in liquid funds.
Reality: Redemptions in liquid funds are processed and credited to your bank account within 24 hours on business days. If you are willing to wait for 24 hours to get the funds in your bank account, then liquid funds are the best investment choices for your short term / emergency needs because they give much higher returns than your savings bank account. There is no lock in period or exit load. This means that you can draw your money at any time, without paying any penalty. In our view, for most short term fund usage for average households, liquid funds give adequate liquidity along with higher returns, provided investors plan their cash-flows a little better.
Misconception 3: Your salary account is often your main savings bank account. Investing in liquid funds require a lot of money and paperwork.
Reality: Corporate houses and institutional investors invest their short term funds in liquid funds. However, liquid funds are also good investment choices for retail investors. You do not need to save a lot of money to invest in liquid funds. You can start investing liquid fund with just Rs 5,000. Additional investments of just Rs 1,000 or more can be made in liquid funds. Extensive paperwork is not required for investing in liquid funds. If you are a first time investor in mutual funds, you need to submit your KYC documents (identity and address proof) and once you are KYC compliant, you can invest in liquid funds by submitting a simple application form by providing your personal details, investment details and bank details. For additional investments (in the same folio), the paperwork is even simpler. If you have a financial advisor, he / she can take care of most of the paperwork on your behalf. Most Asset Management Companies also offer online transaction capabilities for both new and existing investors, whereby you can make investments or redemptions in just a few minutes.
Other Features of Liquid Funds
- You can invest in direct or regular plans, depending on your own investing experience and knowledge. New or less experienced investors are advised to go for regular plans through a financial advisor, while experienced investors may choose invest in direct plans for higher returns.
- You can choose between multiple options like Growth, Dividend or Dividend Re-investment depending on your investment tenor, income needs and tax situation. You should consult with your financial advisors, if you have any question regarding different investment options.
- If you have surplus funds but do not know where to invest or are unsure about market conditions, then you can park your money in liquid funds, accruing higher returns while you get more clarity about where to deploy your funds. Once you have decided where to invest, you can switch your money from liquid funds to the investment of your choice at any time, without any penalty.
- If you have lump sum funds which you wish to invest in equity mutual funds but are unsure about the timing of your investment, you can invest in liquid funds and then transfer your investment in a systematic manner over time to the fund of your choice through Systematic Transfer Plan (STP). STP will help you smoothen out volatility and help average the cost of your investment.
- Liquid funds are ideal for investment tenors of around 3 months. For longer tenors of up to a year, though liquid funds can give good returns, other types of very short duration funds like ultra-short term funds, money market funds and low duration may give slightly higher returns.
According to recent SEBI regulations, all debt and money market securities of maturities more than 30 days need to be marked to market. This may cause some volatility in liquid fund NAVs, with respect to securities which have maturities of more than 30 days. If you intend to invest for just a few days, then overnight funds might be the more safe option. However, in Advisorkhoj’s view, keeping returns, safety and liquidity of the average retail investor in mind liquid funds are the best investment choices for tenors of up to 1 year.
Liquid funds can help investors make their idle money work instead of keeping them in savings bank accounts. Liquid funds are ideal for parking funds for a period of few days, few weeks or few months. It is the best investment choice for money that investors may need to use at short notice and not commit to longer term investments like fixed deposits, post office small savings schemes, bonds / stocks / mutual funds etc. Liquid funds offer high degree of safety and liquidity, while giving better returns compared to savings bank account. We in Advisorkhoj, think that retail investors should educate themselves about these wonderful short term investment options. It is only lack of awareness that is preventing investors from making their short term funds work harder for them. Investors should consult with financial advisors, if liquid funds are suitable for their very short term investing needs.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.