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Liquid Mutual Fund – Features, Suitability, Advantages and Disadvantages

Last Updated : 30 Oct, 2023
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What is Liquid Mutual Fund?

Liquid Mutual Funds, also known as money market funds, are defined as a type of fund that offers investors a secure and highly liquid option to invest their extra cash or short-term funds. They act as a connection, between savings accounts and other investment options like equity or debt funds. Liquid Mutual Funds primarily invest in short-term money market instruments such as Treasury Bills, Commercial Papers, Certificates of Deposits, and term deposits with a maturity period of up to 91 days. These funds provide a combination of safety, liquidity, and the potential for returns compared to regular savings accounts.

How do Liquid Mutual Funds Work?

Liquid Mutual Funds gather money from investors and primarily invest it in low-risk short-term debt instruments that can be easily converted into cash. The main goal of a Liquid Mutual Fund is to safeguard the capital while generating returns. This makes them an ideal choice for parking surplus funds or for those seeking an alternative to savings accounts. Investors in a Liquid Mutual Fund receive returns in the form of dividends with the Net Asset Value (NAV) reflecting the, per unit market value of the funds investments.

1. When investing in a Liquid Mutual Fund, the invested money is combined with funds, from investors. This creates a pool of capital that the fund manager utilises to invest in short-term debt instruments.

2. The fund manager strategically allocates the pooled funds into assets such as treasury bills, certificates of deposit commercial papers, and other money market instruments.

3. Due to their investment in rated short-term debt instruments Liquid Mutual Funds are considered low-risk investments. These instruments are typically supported by government or corporate entities with creditworthiness.

4. A notable feature of Liquid Mutual Funds is their liquidity. Investors have the flexibility to redeem their units at any time without any exit load or substantial penalties.

5. The returns from Liquid Mutual Funds mainly consist of interest income and capital appreciation. While these returns may be relatively lower compared to equity funds they offer stability and predictability.

6. Liquid Mutual Funds determine their Net Asset Value (NAV) on a basis. The NAV represents the, per unit value of the fund. Reflects the performance of its underlying assets.

Features of Liquid Funds

1. Low Risk: Liquid Mutual Funds are considered one of the investment options due to their investments, in short term debt instruments with high credit ratings. They are not as influenced by market volatility compared to equity funds.

2. Easy Access to Funds: These investment options provide access to funds allowing investors to withdraw their investments whenever they need to. The process of redeeming the funds is simple. Usually does not involve any charges or substantial penalties.

3. Attractive Investment Returns: Although Liquid Mutual Funds are not primarily intended for generating capital gains they offer returns when compared to savings accounts or fixed deposits. Investors can anticipate returns, than those offered by regular bank savings accounts.

4. Differentiation: By investing in a Liquid Mutual Fund investors can gain exposure, to a diversified portfolio of short-term debt instruments. This diversification helps mitigate the impact of defaults or credit risks associated with instruments.

5. Transparency: Liquid Mutual Funds adhere to regulations. Maintain transparency. Investors receive updates on their investments, including the Net Asset Value (NAV) portfolio holdings and performance.

Purpose of Liquid Mutual Funds

The purpose of Liquid Mutual Funds is multifaceted in an investors portfolio;

1. Capital Protection : The aim of Liquid Mutual Funds is to safeguard your capital. They invest in risk and highly liquid assets minimising the possibility of capital erosion.

2. Easy Access to Funds: These funds are suitable for individuals who may need access to their investments. Investors can redeem their units at any time. The funds are typically credited to their bank accounts within 1-3 working days.

3. Temporary Money Parking: Investors often utilise Liquid Mutual Funds as a parking space for their money. This can include funds waiting for investment opportunities in asset classes or money kept aside for emergencies.

4. Accomplishing Short Term Goals: Liquid Mutual Funds are well suited for achieving term goals, such as saving up for a down payment on a home planning a vacation or building an emergency fund.

Who Should Invest in Liquid Mutual Funds?

Liquid Mutual Funds cater to a range of investors:

1. Investors with Short Term Financial Goals: Individuals who have term goals such as saving for a vacation, wedding or upcoming expenses can benefit from Liquid Mutual Funds. These funds offer the flexibility of withdrawals without compromising on safety.

2. Emergency Fund Builders: Many people choose Liquid Mutual Funds when building an emergency fund because they strike the balance between safety and liquidity ensuring access, to funds when needed.

3. Corporations and Institutions: Corporations and institutions often invest their surplus funds in Liquid Mutual Funds as a way to earn returns compared to traditional bank savings accounts while maintaining liquidity.

4. Retails Investors : If you are an investor seeking an alternative, to savings accounts or fixed deposits you might want to consider looking into Liquid Mutual Funds. They offer the potential for returns. Provide easy access, to your funds when needed.

Factors to Consider Before Investing in Liquid Mutual Funds

1. Investment Timeframe: Liquid Mutual Funds are most suitable, for short term investment goals. If you have an investment horizon it might be wise to explore fund categories that align better with your objectives.

2. Risk Assessment: While Liquid Mutual Funds generally carry risk it isessential to acknowledge that no investment is entirely risk free. Evaluate your risk tolerance. Ensure that this particular fund category matches your risk profile.

3. Expenses Evaluation: Take into account the expense ratio of the fund as it can impact your returns. Typically lower expense ratios are more favorable for investors.

4. Performance Analysis: Review the performance of the fund to gain insights into its consistency and ability to generate competitive returns.

5. Tax Considerations: Understand the tax implications associated with investing in Liquid Mutual Funds. Depending on your countrys regulations short term capital gains may be taxed differently from long term gains.

6. Exit Load Verification: Although Liquid Mutual Funds usually do not impose exit loads its crucial to confirm this with the fund you are considering as some funds might have exit loads, for redemptions made within a very short period.

Advantages of Liquid Mutual Funds

1. Easy Access to Funds: Having liquidity means that investors can quickly and easily access their money when needed which makes these funds suitable for fulfilling term financial requirements.

2. Capital Preservation: Liquid Mutual Funds primarily invest in low risk assets, which helps protect and preserve the capital invested making them a great choice for safeguarding your funds.

3. Attractive Returns: These funds typically provide returns that are higher than what you would earn from traditional savings accounts. This makes them an appealing option for parking funds and potentially earning better returns.

4. Risk Spreading Through Diversification: Investors benefit from diversification as the fund spreads its investments, across short term debt instruments. This strategy helps mitigate risk by distributing it among assets.

Disadvantages of Liquid Mutual Funds

1. Lower Returns: While Liquid Mutual Funds do offer returns when compared to bank savings accounts their returns are lower, than those of equity or other funds with higher risk levels.

2. Market Risk: Although Liquid Mutual Funds are generally considered risk they are still susceptible to market fluctuations. While the impact is relatively minimal compared to equity funds changes in interest rates and credit risk can potentially affect the performance of these funds.

3. Limited Capital Appreciation: Liquid Mutual Funds primarily prioritise capital preservation and liquidity. If your goal is to achieve capital appreciation it may be worth considering investment options such as equity funds or real estate.

4. Taxation: The way gains from Liquid Mutual Funds are taxed may not be as favourable compared to investment options. In some countries short-term capital gains from these funds might be subject to tax rates.

5. Not Suitable for Long Term Goals: These funds may not be ideal for term goals, like retirement planning or wealth creation. If you have an investment horizon it would be advisable to explore mutual fund categories that align better with your objectives.

6. Opportunity Cost: Although Liquid Mutual Funds offer safety and easy access, to funds there could be a trade off. If these funds were instead invested in slightly higher risk options they might yield returns.

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