Liquid funds are a type of debt mutual fund.

Liquid funds are the least-risky mutual funds. Their risk is almost the same as that of a savings bank account.

This is why many people use liquid funds to store money instead of a savings bank account.

  • Liquid mutual funds mostly invest in instruments with a high credit rating (AAA or AA).
  • Unlike other funds, the NAV of liquid funds is not as volatile. The only change in their NAV is mostly a result of the interest income that accrues.
  • Another notable benefit of liquid funds is that they do not have any entry or exit load as is applicable to every other category of mutual funds.

1. Liquid fund returns

Liquid funds have given returns in the range of 6-8% per annum.

The returns given by liquid funds do not change much and are very stable.

It is this stability that allows people to store money in liquid funds without worrying about market conditions or volatility.

2. Liquid funds vs other debt funds

Liquid funds are also a type of debt fund. Compared to other debt funds, liquid funds are the least risky.

Liquid funds are unique with respect to the applicability of Net Asset Value (NAV). For investments made till before 2 pm on a particular transaction day, the units are allotted on the previous day’s NAV.

Thus liquid funds are the only category to get the previous day’s NAV.

For redemption made till 3 pm on a particular transaction day, the units are redeemed at the same day’s NAV and the proceeds are credited to the bank account in the following morning.

3. How to choose a liquid fund

Here are some parameters you should look at when selecting a liquid mutual fund.

  • Expense ratio

This is one of the most important numbers you should look at while choosing a liquid fund.

Most liquid funds perform similarly. But their expense ratios can vary.

The expense ratio shows the operating efficiency of a mutual fund scheme. It indicates how much of your invested amount is being used to manage the expenses of the fund.

A lower expense ratio translates into higher take-home returns for the investor.

  • Returns generated

The fund’s performance plays a crucial role in the selection of appropriate funds.

You may seek funds which have delivered consistent returns over different time horizons.

You should choose funds which have outperformed their benchmark and peer funds in a consistent manner across 3, 5 and 10 years.

  • Mutual fund company history

History of the fund house becomes an important criterion while selecting a liquid fund.

Fund houses which have a strong history of consistent performance and returns in the investment domain may be trusted to stay robust even during slumps and market rally.

A fund house that has a consistent track record for at least say 5 to 10 years is the one that you can invest in.

  • Other financial ratios

In addition to using plain vanilla returns, there is a range of financial ratios available which can be used to analyze the performance of the fund from different angles. You may employ tools like:

1) Standard deviation- It measures how much an investment’s returns can vary from its average return. It is a measure of volatility and in turn, risk.

2) Sharpe ratio- Returns on every additional unit of risk taken.

3) Alpha- The excess return of the fund relative to the return of the benchmark index is a fund’s alpha.

4) Beta- It measures the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.

A fund having a higher standard deviation and beta is riskier than a fund with lower beta and standard deviation. You should look for funds with a higher Sharpe ratio which means it gives higher returns.

4. Taxation: how liquid funds are taxed so low

Taxes on liquid mutual funds are of two types depending upon the period for which they are held. Here are the two types are:

Short-term Capital Gain Tax: This is applicable to liquid funds held for a period of 36 months or less i.e. anything less than 3 years. In short-term capital gain tax, tax on funds is calculated as per income tax slab of the individual, i.e. 5%, 20% or 30% on the amount of gain.

Long-term Capital Gain Tax: This is applicable to debt mutual funds held for a period of 36 months or more i.e. anything more than 3 years. In the long-term capital gain tax, tax on funds is calculated at the rate of 20% with cost indexation on the amount of gain.

Indexation is the adjustment of your purchase price with respect to the effect of inflation and helps you to pay low taxes on your capital gain.

Example of Indexation:

Particulars Fixed Deposits Debt Funds
Invested Sum 10 lakhs 10 lakhs
Return Rate (Assumption) 10% 10%
Lock-in-Period 5 years 5 years
Total Fund Worth 15 lakhs 15 lakhs
Inflation per Year 6% 6%
Indexed Investment Sum 14 lakhs
Taxed Amount 5 lakhs 1 lakhs
Tax to be paid 1.5 lakhs 20,000
Possible returns after tax 3.5 lakhs 4.8 lakhs

Assumption: The calculations have been made taking into account that the investor falls in the 30% tax bracket.

Liquid funds are not as sought after because they have relatively lower returns when compared to equity mutual funds.

But the point many are missing here is that that is a wrong comparison. Liquid funds shouldn’t be used for growing wealth. It should be used for storing wealth.

Happy investing!

Disclaimer: the views expressed here are of the author and do not reflect those of Groww.