What Is Liquid Fund – A Complete Guide To Help You

Posted on Jan 2 2018 - 12:43pm by Editorial Staff

Instead of letting your cash stay in a saving bank account, why not put it where it can fetch high returns? A liquid fund is such an option which not only helps you grow your money, but is also asa useful investment avenue to reap the benefits of market returns in a short period. The risk is less, though not negligible. Let’s discuss what is liquid fund and what it entails.

What is Liquid Fund?

A liquid fund is a type of debt oriented mutual fund which primarily invests in investments like treasury bills, commercial papers, term deposits and certificates of deposit, which have very short maturities. Investors make use of liquid funds when they have excess cash which they may need in a few days, weeks or months.

How Can You Use Liquid Funds ina Systematic Transfer Plan?

If you want to invest a major portion of your sum in an equity fund, but want to stagger your investments over a period, you can invest your money in a liquid fund and opt for the systematic transfer plan (STP). As per this option, a fixed sum of money from your liquid fund would be transferred to an equity fundon a monthly basis. Say, you have Rs 2 lakh sitting idle in your saving account (earning areturn of 2%-3% per annum), and you would like to invest this money in equities to fetch the long-term returns.

However, you are wary about the short-term variations of the stock markets. In such a situation, you can park your Rs 2 lakh in the liquid fund and initiate an STP into the equity fund of your choice. Over the period, Rs 2 lakh from your liquid fund would get transferred to the equity fund chosen by you.

In this way, you will be able to safeguard yourself from the risk of making a lumpsum investment into the market. You will be benefitedby making a systematic investment,and at the same time, your unused balance will earn more returns than what they would have in the savings accounts.

Benefits of Liquid Funds

Liquid funds do not come with a lock-in period. Moreover, withdrawals from liquid fundsare processed within 24 hours on business days. Unlike other debt funds, liquid funds offer alow-interest rate, as they primarily invest in fixed income securities which have ashort tenure. Further, they do not come with entry and exit loads.

Returns Associated with Liquid Funds

Liquid funds are usually counted among the best investment options for a short duration duringthe inflation environment. Usually, when the inflation is high, the Reserve Bank of India (RBI) keeps interest rates high and tightens liquidity, which in turn help liquid funds to fetch high returns. Moreover, over the past few years, liquid funds have given more returns than bank fixed deposits which levy penalty on premature withdrawal.

Are Liquid Funds Risk-Free?

Though liquid funds carry low risk; they are not risk-free. Owing to their relatively short maturity periods, they always carry some risks. Moreover, your liquid fund, like another mutual fund scheme, invests in market-oriented securities. When the price of these securities moves up or down, the mutual fund’s net asset value (NAV) also gets hampered. When the bond held by a liquid fund defaults, a fund house also needs to write off its value. It may hurt the fund’s NAV.

Liquid funds are a low-risk instrument, however, they can’t be termed totally risk-free. Therefore, it is always advised to stick with liquid funds of large and reputed Asset Management Companies (AMCs), which are backed by strong research teams.

How Are Liquid Funds Taxed?

Though dividends received under liquid funds are not taxed in the hands of the investor, fund houses pay dividend distribution tax. Moreover, those investors who earn profits on their liquid funds in less than one year also have to pay tax at the same rate as per their income slab. If the investor redeems liquid fund units after a year (which is likely to happen as liquid funds are for theshort-term purpose), they would have to pay a long-term capital gains tax.

To sum it up, liquid funds are an effective way to invest your money that otherwise would have sat idle in the bank account. They not only give reasonable returns but also give the comfort of easy liquidity over other investment options like bank fixed deposits.

About the Author

Editorial Staff at I2Mag is a team of subject experts.