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What is a liquid fund?

A liquid fund is a debt mutual fund scheme that carries minimal risk. It is considered a safe investment option for the short term.

(Read more: What is a debt fund?)

For example, say, you have recently sold off a plush property in Navi Mumbai. Chances are that the money is idling in your bank account. You are probably waiting for the bank deposit rates to go up before you make a more meaningful investment. Wouldn’t it be nice if you could find a place to park the funds in the meanwhile?

A liquid fund can help you achieve just that. It keeps your money relatively safe, besides giving you higher returns compared to savings bank accounts or even fixed deposits.

What do liquid funds do

Liquid funds invest in money market instruments on your behalf. They work in the same way as other debt funds. The only difference compared to other debt funds is that these investments are short-term. The investments could be in bonds, treasury bills, government securities, debentures, and so on. They are called debt instruments because they are a kind of borrowing mechanism for companies, banks, and the government. When the market prices of these securities move up or down, the net asset value (NAV) of the liquid fund also changes. (Read more: How to calculate the NAV of a mutual fund?)

How does Liquid Funds work?

Liquid funds follow the same principles as debt funds.

You give money to fund managers. Other investors also chip in. The money is pooled and invested in debt instruments. The company returns the money to you along with interest over a short period of time.

Liquid funds invest in securities with a residual maturity of up to 91 days.

The schemes are the least volatile because of the short-term maturities of the money market instruments. These schemes have become popular with institutional investors and high-net-worth individuals who have short-term surplus funds.

Advantages of liquid funds

  • Assets invested are not tied up for a long time:

    Liquid funds are ideal for parking your money for the short term. Unlike a fixed deposit or equity mutual fund, there is no need to stay invested for a long time. You are free to move out at any time.

  • They do not have a lock-in period:

    Bank fixed deposits require you to stay invested for a mutually agreed period. This could vary from a minimum of three months to five years. The bank will penalise you if you break the fixed deposit in between. For some mutual funds like equity-linked savings schemes (ELSS), there is a lock-in period of three years. With liquid funds, there is no such obligation to stay invested for a minimum period.

  • Liquid funds offer better liquidity:

    Liquid funds get their name from the high liquidity that they offer. Redemptions can be claimed by as early as 10 a.m. the next day. But there is a small catch here. You can only redeem up to Rs 50,000 per folio per day. Therefore, it is good to have more folios. This would allow you to redeem more in a single day if the situation demands.

  • Offers growth and dividend payouts with weekly or monthly frequencies:

    Perhaps you are uncertain about when you would like to redeem the investments in a liquid fund. You could opt for growth where the appreciated units add to your portfolio. You can also choose the dividend payout option, which is done on a weekly or monthly basis.

  • You can move the funds at any time:

    With liquid funds you are free to move your investments to equity funds whenever you feel the valuations are right.

  • A liquid fund can be your contingency fund:

    You need to maintain a contingency fund to overcome unforeseen situations. There could be job loss, ill health, or a temporary setback in your business, all of which will require money to tide over the crisis. You may be keeping this amount in your savings bank account. If you put the money in a liquid fund instead, you will earn more.

Are Liquid Funds really safe?

Mutual funds are subject to market risks. So, it would be wrong to assume that a mutual fund investment is entirely safe. Since the interest payments are fixed and the principal amount is returned, debt instruments are considered low-risk, low-return financial assets. The same applies to liquid mutual funds which fall under the debt fund category. They are considered to be relatively safer than other types of liquid funds.

(Read more: How to choose a mutual fund scheme?)

Bank account or liquid fund: Which is right for you?

Liquid funds compete with savings bank accounts. Both offer similar benefits like high liquidity. But the biggest differentiator is the interest income. A savings account will fetch you 4% interest, whereas a liquid fund can give you at least 7% returns, if not more. Banks too have realised this. Some have raised the interest rate of savings accounts to 5–6%, which brings them almost on a par with liquid funds. If earning more from your surplus funds is your objective, a liquid fund would be the right choice for you.

WHAT NEXT?

We are almost at the end. Before you start investing in mutual funds, there are a few more important points to keep in mind like taxation. This can affect your total financial returns. To know about these factors, Click here

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