What are liquid funds and why should you invest in them?

Emergencies don’t come knocking at the door. So, to be prepared for life’s unexpected challenges, it’s essential that you strengthen your defenses. Having a financial cushion in times of crisis can ensure that you aren’t caught off-guard by any current unforeseen financial emergency. And that’s why, maintaining liquidity is a crucial part of a sound investment strategy.

Liquidity in investment determines how soon your assets can be transformed into cash. One of the most preferred ways to ensure liquidity is by investing in liquid funds. Before we dive deep into what are liquid mutual funds, let’s have a look at the various types of mutual funds:

Types of mutual funds

Some of the most common types of mutual funds are mentioned below:

• Equity funds
• Debt funds
• Hybrid funds
• Exchange trade funds
• Funds of Funds
• Solution-oriented funds

What is a liquid mutual fund?

A liquid mutual fund is a type of a debt fund that invests in money market instruments such as treasury bills, commercial papers, certificates of deposits, government securities, etc. Liquid funds come with a maturity of up to 91 days and can be redeemed within 3 business days as per regulations but market practice is T+1 day. Usually, the returns offered by liquid funds tend to be better than the interest rate offered by savings bank account with a caveat that returns are subject to market volatility in case of liquid funds as compared with bank savings account. This makes liquid funds a preferred option for short-term investors looking to park their surplus funds for better yields.

How does a liquid mutual fund work?

So, now that you’re aware of what are liquid funds, let’s have a look at how liquid mutual funds actually work.

1. Pool of money: Several investors put their money into a liquid mutual fund, which is then pooled by the fund manager
2. Investment in short-term debt instruments: The fund manager then invests the pooled money in short term & highly liquid money market instruments with a maturity period of up to 91 days. These instruments provide low-risk, low-return investments that create income for the fund.
3. Income is distributed among investors: The generated income is then distributed among the investors. The income distribution can be through Income Distribution cum Capital Withdrawal (IDCW), or in case of growth option, it will reflect in NAV.
4. Redemption: Investors can redeem their investment easily by placing a redemption request with the fund house.

Is it ideal for you to invest in liquid mutual funds?

Irrespective of what your financial goals are, you can consider investing in liquid mutual funds. It’s because these funds offer easy liquidity, low-risk, and relatively stable returns that can be extremely helpful in case of any unforeseen events such as medical exigency, job loss, or other unexpected expenses. Having said that, it is always advisable to seek the help of a financial expert before making any investment-related decision.

When should you consider investing in liquid mutual funds?

Investing in a liquid mutual fund can be useful in the following scenarios. Some of them are mentioned below:

1. To create an emergency fund that offers financial cushion during unforeseen events.
2. To accomplish short-term goals such as planning for an exotic vacation, saving for down-payment for a home or a car.
3. To park surplus cash for better returns without compromising on liquidity.

Factors to consider before investing in liquid mutual funds

Here are some key factors to consider before investing in liquid funds:

1. Expense ratio: You must check the expense ratio of the fund before investing in it. The expense ratio indicates the amount of money you would be paying to the Asset Management Company as a fee to manage your investments.
2. Credit quality of underlying securities: Liquid mutual funds invest in short-term debt instruments. You must evaluate the credit quality of the underlying instruments to analyse the risk associated with the fund. The higher the credit quality, the lower is the risk of default and vice versa.
3. Liquidity: The most important feature of a liquid fund is that it can be easily redeemed, and thus can help you have instant access to cash, whenever required. Thus, before investing in a liquid fund, you must carefully check the redemption process, the time taken to receive the redemption proceeds, and the maximum amount that can be redeemed in a day.
4. Risk and Return: You must carefully evaluate the risk and return profile of the liquid fund before investing.

To sum it up, a liquid mutual fund can be considered an ideal investment option for a short term investment horizon. It not only allows investors to park their excess funds but also helps in generating reasonable returns.

FAQs:

What are the underlying instruments of liquid funds?

Liquid funds primarily invest in money market instruments such as commercial papers, certificate of deposits, term deposits and treasury bills.

What factors impact the returns offered by liquid funds?

The returns offered by liquid mutual funds are impacted by several factors such as prevailing interest rates, the credit quality of underlying risks, and the costs incurred by the fund manager.

How to invest in liquid funds?

You can easily invest your money in liquid mutual funds by contacting a distributor or through the website of a fund house. You will have to communicate your personal details, along with the investment amount and duration to make the investment.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.

This document should not be treated as endorsement of the views/opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.