What is a liquid fund?
It is a mutual fund scheme that primarily invests into fixed-income instruments of very short duration such as overnight, a week or a month. Liquid fund schemes are also known as ultra short-term mutual funds. Most of the investments made by the scheme can be liquidated at a very short notice. There is no entry and exit loads. In most cases, the fund houses honour redemption request within two days of placing the redemption request. Investors are given growth and dividend options. Within dividend option, investors can choose daily, weekly or monthly dividends depending on their investment horizon and investment amount.
Where does it invest?
The portfolio of a liquid fund comprises treasury bills, CBLO, certificate of deposits and commercial papers. The aim of the fund manager is to invest only into liquid investments with good credit rating with very low possibility of a default. The returns typically take the back seat as protection of capital remains of utmost importance.
For whom?
The product works the best as a parking facility for most of the investors. It offers to work as a capital protector, though it does not guarantee that. One can expect it to earn some returns, better than the savings bank account, in the short term. Corporate entities prefer to park their money for very short durations. Even high net worth individuals prefer them over a savings bank account. With mutual funds going online, individual investors with small sums as low as Rs 25,000 can look at them as an effective short-term investment option over their savings bank account. The rates of interest at the short duration are inching upward with the monetary policy tightening by the Reserve Bank of India. The loan rates have already inched upwards. There are some banks that have passed on the benefits to the fixed-deposit investors, primarily at the longer end, say for one year and above. But the short-term fixed deposits are yet to move up. Investors seeking participation in the upward moving short-term interest rates regime may do well with the liquid and liquid plus funds taking into account their needs.
Investor's strategy
Investors looking out for opportunities in equities and long-term fixed income instruments can park their money in the liquid or ultra short-term funds in the meantime. Investors with slightly long holding period in mind, say a month, can look at liquid plus schemes that may offer a bit longer durations aiming higher coupons and a more favourable tax treatment. Liquid plus funds may see negative returns in the short term due to a change in valuation policy. Control over expenses in the form of low expense ratio, good overall credit quality of the portfolio and a disciplined approach to investing are some of the key ingredients of a good liquid fund.
Tax treatment
There is a dividend distribution tax of 28.33% on liquid funds, whereas 14.16% is levied on liquid plus funds in case of individual investors. This looks attractive when compared with the highest marginal rate of income tax (33.66%) payable on the interest earned on fixed deposits.
