InvestorQ : I am looking to invest in some liquid funds for the short term. What are the pros and cons that I should remember about these liquid funds?
Rutuja Nigam made post

I am looking to invest in some liquid funds for the short term. What are the pros and cons that I should remember about these liquid funds?

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Arti Chavan answered.
11 months ago

Liquid funds are mutual funds that invest in very short term debt instruments like treasury bills, call money, CDs, CPs, government securities with maturity of less than 1 year etc. It has some unique advantages, especially when you compare with savings account in a bank. Here are some of the key merits vis-à-vis savings deposits.

· An average savings account in a bank gives returns of 3.5% to 4%, in pre tax terms and 2.8% in post tax terms. With banks shifting to external benchmark based lending rates, these savings rates have now come down closer to 3%. In case of liquid funds you can look to earn on an average around 6% in pre tax terms and nearly 4.5% in post tax terms. In fact, post tax returns can be further improved if you stick to SWP structure for returns.

· The good thing is that most liquid funds also offer instant redemption access facility on withdrawals up to Rs.50,000 and for larger amounts, the redemption is processed on T+1 day. Some of the funds that are linked to banks also offer you the special facility of checking facility against the receivable on the fund. This is an added advantage.

· There is no lock-in period that is applicable to liquid funds and you are free to sell the same as soon you are allotted units. Normally, there is also no exit load on liquid funds and that makes it ideal for STPs and also for systematic withdrawal plans of mutual fund payouts.

· Liquid funds are a lot more flexible. You can structure these liquid funds in the form of systematic withdrawal plans (SWP) so as to convert the payouts into capital gains and make them more tax efficient.

· Liquid funds are a good means for parking your emergency funds since the price risk is almost nil in these liquid funds.

However, there are two challenges of liquid funds that you must be familiar with.

· There is nothing like capital assurance on liquid funds. For example, in a savings bank account, investments up to Rs.1 lakh are covered under deposit insurance. No such feature exists for the Liquid Funds and the entire investment is technically a risk investment. That is why you must look at the portfolio of a liquid fund very closely to ensure that it is actually invested in very safe instruments.

· While liquid funds are technically, risk-free, there is the black swan events when these liquid funds can also become extremely volatile. Also, some of the versions like liquid plus funds have a risk of exit load and also debt that is not all that liquid.

· Lastly, any liquid fund is now required to mark to market any debt that is of more than 30 days tenure compared to 60 days earlier. This is likely to impact returns on liquid funds.