Liquid Fund

Even though we all have bank accounts, we don’t need to put all our idle money there. There’s another animal that works almost like a bank account but fetches you a bit more than a bank account and is almost as safe as a bank account. It’s called a liquid fund and here’s why it should be there in your portfolio.

Higher returns

Your money that lies in a savings bank account fetches you 4% interest per annum. Some banks offer a slightly higher interest rate of 6%. However, the best liquid funds have returned as high as 7.5-8% on an average in the past 1-year period, daily, on an annualised basis. On returns alone, liquid funds score over a savings bank account.

Additionally, dividends declared by liquid funds are currently subjected to a dividend distribution tax of 28.84% (including surcharge and cess). On the contrary, your bank interest gets taxed at income tax rates (30.9% for the highest tax bracket; including surcharge). For an investor in the 30% tax bracket, a dividend plan works out to be slightly more tax efficient as well (see table).

“A liquid fund can make use of opportunities in the fixed income market to make additional returns. Savings bank accounts cannot do so,” said Akhil Mittal, senior fund manager (fixed income), Tata Asset Management Ltd. He added that historically, liquid funds have returned more than a savings bank account.

Back of the envelope calculations show that even if you are in the 10% and 20% tax brackets, you stand to earn more in a liquid fund, post-taxes, than from a savings bank account.

“Liquid funds also help to swipe away balances from your bank so that you can avoid impulsive spends from your debit card. They are a must for retail investors as well,” said Lovaii Navlakhi, a Bengaluru-based financial planner.

Contingency planning

Financial planners recommend that investors must build a contingency fund (typically 3-6 months of their expenses) through a liquid fund.

“What we have observed is that many people start their SIPs (systematic investment plans) in equity mutual funds. But when faced with an emergency expense, they first break their SIPs and use that money,” said Anup Bhaiya, managing director and chief executive officer, Money Honey Financial Services Pvt. Ltd.

Others offer a similar opinion. “We advise our clients to do an SIP into liquid funds till the time the liquid fund corpus reaches to a level that they want to accumulate,” said Karthik Jhaveri, director and founder of financial advisory Transcend Consulting India.

Bhaiya said that most of the times when his clients wish to start SIPs in equity funds, they don’t come with the idea of putting away some money in liquid funds to build an emergency corpus. But distributors and financial advisers recommend some money to be put away in a liquid fund, along with equity funds.

A path to equity funds

SIPs are a popular way to invest in equity funds. But most of us tend to transfer our money from our savings bank account to the chosen equity funds. That works if we plan to channelise our regular cash inflows in a sense that our income first comes to us in our bank account and from there it finds its way into an equity fund. But what if there is a lumpsum to invest?

Here too, systematic transfer plans (STPs) earn a bit more than a traditional SIP because the idle money that lies in your liquid fund earns a slightly higher return (in the range of 7-8%) before it gets deployed in an equity fund.

“Investors can also use liquid funds as a parking area whenever they need to book profits in their equity investments, such as in equity MFs (mutual funds). Let the money lie in a liquid fund, before they decide what they want to do with it—whether to deploy it back into equity MFs or to withdraw,” said Jhaveri.

Note that in cases of STPs, you need to ensure that your liquid funds and equity funds belong to the same fund house. You won’t be allowed to transfer your money from a liquid fund belonging to fund house A to an equity fund of fund house B.

Ultra short-term bond funds

A close cousin of liquid funds is ultra short-term bond funds. While liquid funds can invest only in securities that mature up to 91 days, ultra short-term bond funds can invest in slightly higher maturity scrips. As a result, they stand a chance to earn slightly higher returns. The downside is that their risk profile also goes up as they are more prone to volatility, compared with a liquid fund.

According to rules laid down by the capital markets regulator, Securities and Exchange Board of India (Sebi), all scrips that mature up to 60 days are to be accounted for, on an accrual basis. Scrips that mature after 60 days must be valued on a mark-to-market basis. In simple words, an accrual method means that the interest of the underlying security is amortised over the tenure of the scrip and the daily interest so arrived, is then added to the price of the scrip at which it is bought. The net asset value (NAV), therefore, keeps going up at a steady pace, daily. Your liquid fund gets back its entire principal at the end of the tenor.

For securities that trade beyond 60 days, debt funds have to take their market or traded price. Since a large chunk of ultra short-term bond fund’s assets lie in scrips that mature beyond 60 days, they are subject to volatility.

“Typically, distributors sell ultra short-term bond funds since they get a higher commission in them, than what they get in liquid funds. Ultra short-term funds tend to give higher returns than liquid funds. And retail investors also tend to hold on to their investments for longer time frames, so ultra short-term bond funds can work better for them,” said a chief investment officer of a fund house who did not wish to be named. “Companies that invest in liquid funds do so for a very specific time frame; they, therefore, avoid taking any unnecessary risk,” he added.

Over the past one-year period, ultra short-term bond funds have, on a daily basis, returned as high as 8.5-9% on an annualised basis.

“When we are talking of cash management needs, it’s best to keep it simple and uncomplicated. Hence, liquid funds work ideally for most requirements,” said Ashwin Patni, fund manager and head-products, Axis Asset Management Co. Ltd.

What should you do?

It clearly makes sense to have a liquid fund in your portfolio. Keep the fund’s risk-return profile in mind when you decide whether you wish to choose a liquid fund or venture into an ultra short-term fund. Navlakhi prefers larger-sized schemes as “liquid funds aren’t being invested in for returns but for safety first.”

Choose larger fund houses and schemes when it comes to liquid funds, unless you wish to start an SIP in a particular equity fund, in which case you will have to find a liquid fund within the same fund house. Also, larger liquid funds tend to have lower expense ratios.

It’s also a good idea to start an SIP into a liquid fund to build a contingency fund.