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The Role of Liquid Funds in Your Investment Portfolio

Last updated :
March 10, 2024
/

minutes read

Table of Contents

Introduction

As a young Indian employee or new graduate, managing your finances and investing your money can seem overwhelming. One investment option that you should consider is liquid funds. In this article, we'll explain what liquid funds are, their benefits, how to invest in them, and the risks associated with investing in them.

  • Understanding Liquid Funds
  • Definition: Liquid funds are a type of mutual fund that invests in debt and money market instruments with a maturity period of up to 91 days. They are a low-risk investment option that provides liquidity and safety of capital.
  • Features:
  • The first feature of liquid funds is their low expense ratio. This means that the fees associated with investing in a liquid fund are minimal, which is beneficial for investors who want to maximize their returns.
  • The second feature of liquid funds is that their net asset value (NAV) is calculated on a daily basis. This ensures that investors have an up-to-date view of the value of their investment and can make informed decisions about when to buy or sell.
  • The final feature, liquid funds offer easy entry and exit options. Unlike other types of mutual funds, which may require a long lock-in period, liquid funds allow investors to enter and exit at any time without incurring significant penalties.

For example, let's say you have Rs. 50,000 that you want to invest for a short period of time. By investing in a liquid fund, you can earn higher returns than a traditional savings account, while still having the flexibility to access your money quickly if needed. Additionally, the low expense ratio and daily NAV calculation mean that you can keep more of your returns and have an up-to-date view of the value of your investment.

  • Type of Liquid Funds

There are different types of liquid funds that investors can choose from, depending on their investment objectives and risk appetite. Here are some of the common types of liquid funds:

  1. Overnight Funds - These funds invest in very short-term debt securities that mature within one day, making them the most liquid type of liquid fund.
  2. Liquid Funds - These funds invest in debt securities with a maturity of up to 91 days. They are suitable for investors who want to park their money for a short period of time.
  3. Ultra-Short Duration Funds - These funds invest in debt securities with a maturity of 3-6 months, making them a slightly longer-term investment option than liquid funds.
  4. Money Market Funds - These funds invest in money market instruments such as commercial papers, certificates of deposit, and treasury bills. They are suitable for investors who want to earn slightly higher returns than savings accounts.
  5. Floater Funds - These funds invest in floating-rate debt instruments, where the interest rate is linked to a benchmark such as the MIBOR or the MIFOR. They are suitable for investors who want to hedge against interest rate risk.

It is important for investors to carefully evaluate their investment objectives and risk profile before choosing a type of liquid fund to invest in. They should also consider factors such as the fund's past performance, expense ratio, and portfolio composition to make an informed investment decision.

Benefits of Liquid Funds

Liquid funds are a popular investment option for those who want to park their surplus funds for a short period of time. They offer several benefits that make them an attractive investment option for young Indian employees and new graduates. Here are some of the key benefits of investing in liquid funds:

  1. High liquidity: Liquid funds are highly liquid, which means that investors can easily convert their investments into cash when they need it. Since they invest in short-term debt securities that mature in less than 91 days, they offer high liquidity and can be redeemed quickly.
  2. Low risk: Liquid funds are a low-risk investment option as they invest in high-quality debt securities with short maturities. These securities are rated by credit rating agencies, which help investors assess the creditworthiness of the issuer. Liquid funds offer better returns than savings accounts and fixed deposits while carrying lower risk.
  3. Better returns than traditional savings accounts: Liquid funds typically offer better returns than traditional savings accounts, which makes them a better alternative for investors who want to earn higher returns on their surplus funds. While savings accounts offer interest rates of around 2-3%, liquid funds can offer returns of around 4-6% depending on market conditions.
  4. Tax benefits: Liquid funds offer tax benefits to investors. They are considered as debt funds for taxation purposes, and long-term capital gains (LTCG) are taxed at 20% after indexation, while short-term capital gains (STCG) are taxed at the individual's income tax rate. In addition, investments in liquid funds are eligible for deduction under Section 80C of the Income Tax Act, 1961.
  5. Diversification of portfolio: Investing in liquid funds can help diversify an investor's portfolio. As liquid funds invest in a range of debt instruments issued by different companies and financial institutions, they help spread the risk of investment across multiple securities. This helps reduce the risk of concentration and ensures that the portfolio is not dependent on the performance of a single security.

Liquid funds offer high liquidity, low risk, better returns than traditional savings accounts, tax benefits, and diversification of portfolio. They are a suitable investment option for young Indian employees and new graduates who want to park their surplus funds for the short term while earning higher returns than savings accounts. However, investors should carefully evaluate their investment objectives and risk profile before investing in liquid funds.

How to Invest in Liquid Funds

Investing in liquid funds is a simple process that can be done online or offline. Here are the steps you need to follow to invest in liquid funds:

  1. Eligibility criteria: Any individual who is over 18 years of age and has a PAN card can invest in liquid funds. Most fund houses also allow investments by NRIs, PIOs, and HUFs.
  2. KYC process: Before you can invest in a liquid fund, you need to complete your Know Your Customer (KYC) process. This involves submitting your PAN card, address proof, and identity proof. The KYC process can be done online or by visiting the nearest KYC registration agency or fund house office.
  3. Selection of fund: Once you have completed your KYC process, you can choose a liquid fund based on your investment objectives and risk appetite. You can research various liquid funds and compare their returns, expenses, and other parameters before making a selection. You should also consider the fund house's reputation, track record, and customer service before investing.
  4. Investing through SIP or lump sum: After you have selected the liquid fund, you can invest in it through a Systematic Investment Plan (SIP) or a lump sum. SIP allows you to invest a fixed amount at regular intervals, such as weekly, monthly, or quarterly. This helps in averaging out the cost of purchase and reduces the impact of market volatility on your investment. Lump sum, on the other hand, involves investing a lump sum amount at one go.

To invest in a liquid fund, you can visit the fund house's website or use the mobile app. You can also invest through a broker or a financial advisor. The investment process is quick and easy, and the units are allotted within one business day of receiving the investment amount.

Here are some of the top liquid funds in India, based on their past performance and ratings:

  1. Nippon India Liquid Fund
  2. HDFC Liquid Fund
  3. ICICI Prudential Liquid Fund
  4. Aditya Birla Sun Life Liquid Fund
  5. SBI Liquid Fund

Risks Associated with Liquid Funds

While liquid funds are a low-risk investment option, there are still risks associated with investing in them.

Credit risk is the risk of default by the issuer of the debt instrument, while interest rate risk is the risk of a change in interest rates affecting the value of the investment.

Market risk is the risk of a decline in the market affecting the value of the investment.

However, the risks associated with liquid funds are relatively low compared to other types of mutual funds.

Conclusion

In conclusion, liquid funds can be a valuable addition to an investment portfolio, especially for young Indian employees and new graduates who are looking for low-risk investments with high liquidity and better returns than traditional savings accounts. Liquid funds offer several benefits, including easy access to funds, low risk, tax benefits, and diversification of portfolio.

By investing in liquid funds, young Indian employees and new graduates can park their surplus funds for short-term goals, such as emergency funds, down payment for a house, or a planned vacation. They can also use liquid funds as a parking option before investing in long-term equity funds.

Therefore, we encourage young Indian employees and new graduates to evaluate their investment objectives and risk profile and consider investing in liquid funds to earn better returns than traditional savings accounts while keeping their funds safe and easily accessible. Investing in liquid funds can help them achieve their financial goals and build a strong financial foundation for their future.

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