7 points to know about liquid funds. Meaning, disadvantages, taxation, etc

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Liquid funds are mutual funds that invest in short-term debt securities in order to provide liquidity and capital appreciation to their investors.

The major advantage of liquid funds is that it provides liquidity to investors usually people invest in liquid funds for a shorter period of time.

For example, if a person is searching for a home to buy he may invest the down payment amount in a liquid fund as the maturity period is not known but the withdrawal is certain.

This article contains all the information which an investor needs to know before investing in a liquid mutual fund the information includes the following points given in the table below.

1. Liquid funds meaning

Liquid funds are a type of Debt Mutual Funds that are used to invest money for a very short period of time. In a liquid mutual fund portfolio, a fund manager commonly buys commercial papers, treasury bills, and term deposits usually the period of expiry or maturity of this deposit is 91 days.

It is the most efficient way to park money for a short duration. Mostly the time horizon of bonds included in this fund is of 3-4 months. So investors who want to park money for a shorter duration are well served as compared to other debt funds like ultra short-term debt funds whose maturity is of 1 year.

Related Topic to read: What are open-ended funds

Liquid funds meaning, disadvantages, taxation

2. How liquid funds work

The main investment objective of this fund is capital protection and provide liquidity to investors. Along with a small appreciation in the capital in the form of interest.

The NAV of a liquid mutual fund is calculated for 365 days, unlike other debt funds whose NAV is calculated only for business days. If the units of the fund are purchased before 2 p.m. then the NAV of the purchase unit is considered to be of the previous day.

As its aim is to protect the capital the fund manager buy debt securities that have the highest rating & to protect against any market fluctuation the fund manager usually buys bonds which has a shorter maturity period usually of 3-6 months so that the interest rate fluctuation does not affect the performance of the fund.

If an investor wants to withdraw from the fund he can apply for the same and the amount will be credited to his account on the next business day.

3. Advantages of Liquid funds

a. Liquidity 

The biggest advantage Of a liquid fund is that it provides liquidity to investors who want money to be invested for a shorter duration for different reasons along with capital protection.  The reasons can be down payment to be paid for a house in few months, for which the search is going on, etc.

b. No Lock-in period 

Unlike other Mutual Fund, there is virtually zero lock-in period for liquid funds some funds may have a lock-in period of 1-3 days.

c. No Entry or exit load

Therefore there is no lock-in period there is no Exit load charge on withdrawal of funds and entry load is banned by SEBI

d. Low risk

As the bond is the purchase with the highest credit ratings and the maturity is is generally of 3 months the risk of permanent capital loss is very low.

e. Higher interest than saving deposit

If an investor wants to park his money for a shorter term or if he has access to funds which he is going to invest somewhere in 3 to 6 months he is better off investing in a liquid fund than keeping it in a savings account where the interest rate is comparatively lower.

4. Disadvantages of Liquid funds

a. Drop-in NAV

If the credit rating of any underlying bond or investment falls then the NAV of the fund will also drop. Thus the liquid funds are not risk-free investments.

b. Not covered under Deposit Insurance Scheme

Under the DICGC Act the all the amount deposited in a bank is insured up to 5 lakh rupees; this insurance is not available in the case of the liquid funds as they deal in market securities.

To know more about the DICGC Act update go to Economics times.

5. How to choose mutual funds?

a. Track record

The past performance of the fund should be checked along the rolling period against other funds and industry benchmarks. The returns of liquid funds are generally linear for all the funds,  so an investor should check if there is any diversion on the upside or the downside before investing.

b. Credit rating

An investor should always check whether the fund credit rating is of the highest quality or not, as the most important objective while investing in a liquid fund is capital protection. 

Credit ratings are reports given by credit rating agencies that assess whether the bond will be paid or not by the the receiver of loan.

c. Expense ratio 

As the return delivered by liquid funds and generally linear to the industry as a whole an investor should choose liquid funds with the lowest cost.  The lower the cost of the fund the higher take away return for the investor.

6. Taxation on Liquid Funds.

Taxation on liquid funds is the same as other debt funds. The dividends are added to the income tax slab of an individual for calculating the taxation expenses.

If an investor sells his holding before the period of 3 years the gain will be added to his income tax slab and taxed accordingly. If he sells the units after 3 years then he will be taxed at the rate of 20% along with indexation benefit.

7. How to Invest in liquid funds online & offline.

An investor can invest in liquid funds via opening an account with online aggregators like Groww, etc., or by going to the individual website of the mutual fund companies and invest directly through them. This will be the cheapest way as there would not be a brokerage commission charged.

The investor can also visit the offices of the mutual fund companies to invest directly and save cost

Otherwise, an investor can also invest in liquid funds by going to a mutual fund broker.

For info on Liquid Funds go here:- www.hdfcfund.com

Disclaimer

I am not a SEBI registered investment advisor. This article is for information purposes any scheme or company name mentioned here is just for example & not a recommendation. 

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. The NAVs of the schemes may go up or down depending upon the factors and forces affecting the securities market including the fluctuations in the interest rates. The past performance of the mutual funds is not necessarily indicative of the future performance of the schemes. 

 

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