In simple words, liquid funds are debt mutual funds that pool money from investors and invest it in a very short-term market instrument like treasury bills and government securities. These funds are designed as an alternative to the savings bank account that carries market risk.
The instruments in which liquid funds invest generally mature on or before 91 days. Therefore there is less interest rate risk as the possibility of the NAV reacting sharply to interest movements is small.
Since these bonds mature within a very short term the risk of credit downgrade or default is relatively low. Also, most of these bonds are issued by organisations with high credit ratings.
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A liquid fund is mainly used for parking surplus funds of the investor. It is an alternative to the bank savings account. It is not meant for investing or saving money. In the current market scenario if you want to earn a little extra by holding them, then liquid funds is a better option than a savings account. The average returns of liquid funds are 9.3 per cent which is much better than the rates offered by a bank savings account.
Consider investing in liquid funds in the following scenarios:
It is commonly believed that liquid funds are the least risky and carries minimum volatility in the category of mutual funds. But this myth, i.e. liquid fund NAV cannot fall was busted in the year 2013 when there was a sudden hike in the interest rate overnight by RBI. Liquid funds fell but it regained its pace in the next few days.
In the year 2017, Taurus liquid funds suffered the same fate when Ballarpur industries were downgraded and later defaulted. The funds fell from five-star rating to one-star rating due to credit risk. For the same reason (that they cannot account for credit risk), the fund is currently rated four-star because the NAV moved up a little since Taurus got back part of their money.
See Also: How to Invest in Liquid Funds?
Don’t Merely Go for the Chart-Toppers: in this category, it is difficult for funds to give returns that are significantly different from the other funds unless they consider taking the marginal risk. Hence do not get influenced by the chart-toppers that promises high returns. You can settle for funds with slightly lower returns provided they fulfil your investment criteria like diversifying your portfolio, short- tenure and systematic withdrawal.
Fund Rating Must Be Viewed with Caution: the fund rating of liquid funds displayed by online aggregators is mostly devised by calculating the returns. These online websites do not consider diversification. So, going by the rating along may not be wise when you are thinking to park your money in liquid funds
Fund Houses: many people want to invest in smaller fund houses as they provide unique fund strategies. These fund houses attract treasury money of very large corporate houses and hence have the higher onus to keeps the risks at bay. This ensures more responsibility of the fund manager and in this process; your money too has a better chance of being safe.
Size Matters in Liquid Funds: liquid funds are mainly used by institutional investors for parking their surplus funds in instruments other than a savings account. When the AUM of funds is small, redemptions by institutions with greater exposure can impact the returns. So, funds with thousands of crores can be beneficial rather than a threat when it comes to the liquid fund category.
Look for Diversification: you can also check the concentration or diversification of funds in the underlying instruments. For example, Axis liquid has 134 securities in its investment portfolio. So its exposure to individual securities is low. Hence, so if anyone of its commercial papers are hit, its impact on the NAV of the total portfolio will not be high. On the other hand, a portfolio with just 20 securities will have a higher impact on the overall portfolio in case any one of the funds is hit.
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