Best Top Liquid Funds In India - MF Explorer

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Best liquid funds

What is a liquid fund?

According to SEBI’s Categorisation and Rationalisation of Mutual Fund Schemes, a liquid fund is an open ended liquid scheme that falls under the debt fund category with ‘investment in debt and money market securities with maturity of up to 91 days only’. How do liquid funds work, where do they invest and how does one arrive at the best liquid funds – these are some of the points covered below.

Where do liquid funds invest?

Liquid funds invest primarily in highly liquid money market instruments and debt securities with the objective of providing capital protection and above all, liquidity. Instruments such as Treasury Bills, Commercial Paper and Certificates of Deposit that have residual maturities of less than or equal to 91 days usually find a place in the portfolio of liquid funds.  To provide a little context to understanding what drives the investment decisions of liquid funds, a quick look into the recent history of debt markets is warranted. Specifically, the credit crisis that started off in the wake of defaults by IL&FS and then by other NBFCs and HFCs. This crisis drove home the point that contrary to popular perception, debt mutual funds were not immune to risks. This crisis prompted some careful guidelines from SEBI on debt mutual funds, especially liquid funds. These measures sought to reduce the risk associated with debt funds. Some of the measures put in place that impact investment decisions include:

  • A minimum 20% of assets in liquid instruments such as cash, T-bills and Repo on G-securities
  • No structured obligations
  • Exposure to a single sector limited to 20% as against 25% earlier

What is the nature of returns from liquid funds?

True to their name, liquid schemes prioritise liquidity and capital protection. But this doesn’t mean they are immune to risks and risk and return go hand in hand. By virtue of the debt they invest in, liquid funds are exposed to the following risks:

Interest rate risk

Since liquid funds invest in debt (fixed income) instruments, they are subject to interest rate risk. Debt instrument prices have an inverse relationship with interest rates. Therefore, when interest rates rise, fixed income security prices fall and vice versa. But this inverse relationship is more marked for longer term instruments than ones with shorter terms and since liquid fund invest primarily in short term instruments, they score lower on the interest rate risk that they are exposed to.  

Credit risk

Credit risk comes from the possibility that a borrower will not be able to meet interest or repayment obligations. Here again, being primarily debt driven, credit risk is very much present and made its presence felt when in 2018, IL&FS failed to meet its obligations. The greater the credit risk with an instrument, the greater the expectation of return on the same and vice versa. Which is why the safest avenues to park money will yield very little by way of returns. If the credit rating of the issuer of a security gets downgraded, the security prices will fall and so will the NAV of the fund. In order to reduce credit risk especially in liquid funds, SEBIs tightened guidelines help. However, the tighter guidelines on where to invest mean that liquid schemes have limited avenues to boost their returns.   

Liquidity risk

Liquidity risk arises out of an inability to sell instruments and therefore possibly selling them at a discount. This too has been minimized with a stipulated 20% of assets in liquid instruments and limitations on exposure to a single sector.

What all of these risk minimizing measures translate to is low risk (though they may witness some volatility on a day to day basis) but also low returns.

Suitability and how to use liquid funds?

Due to the lower risk levels and the speed with which the money can be accessed (some funds have features that allow redemptions to hit investor’s bank account in minutes), liquid schemes are ideally suited for investing or parking money for short time periods ranging from a week (for redemptions sooner than a week, a graded exit load will be applicable) to a few months.

  • For instance, if you have found that the time is right to redeem an investment made for a long term financial goal which is just a couple of months away, a liquid fund could be a temporary parking spot for the funds.
  • Liquid funds are also ideal to locate a part of your emergency fund portfolio.
  • Liquid funds can be used for systematic transfer into equity funds within the same fund house or for systematic withdrawal plans to generate income.
  • If a liquid fund is used for investing for anything longer than a few weeks to months, while the money will most likely be safe, you will have compromised on earning better returns.

What is the usually the benchmark index?

The benchmark is an index used to measure the fund’s performance. You will find most funds in this category benchmarked against the Crisil Liquid Fund Index with a few benchmarked against the Nifty Liquid Fund Index.

Taxation

  • IDCW is taxed in the hands of the investor at the applicable slab rate
  • Short term capital gains (gains made on redemption of units held for 3 years or lesser) are added to the taxable income and taxed at the applicable slab rate
  • Long term capital gains (gains made on redemption of units held for more than 3 years) are taxed at 20% after taking advantage of indexation.

How to evaluate liquid funds?

With a long list of liquid funds available, it becomes more important but also trickier to evaluate them to arrive at the best liquid funds. The following are the key attributes that would need to be considered in arriving at the best liquid funds.

  • AUM size – this is a fund category where a larger AUM could prove to be an advantage. Do take a look at our article, ‘Does AUM size impact mutual fund performance?’ which highlights the ways in which AUM size can impact a fund.
  • Yields
  • Consistency of performance across interest rate cycles
  • Performance vis-à-vis category average
  • Riskiness of the scheme –A periodic review of the portfolio and the Riskometer (the Riskometer dynamically captures the risk in a portfolio) will help assess the scheme.
  • The scheme’s position in the Potential Risk Class matrix for debt schemes aims to capture how far the riskiness of the portfolio will go at any time (the maximum risk a scheme can take) without permission from the investors. This may sound confusing but our article, ‘Potential Risk Class matrix for debt funds – what should you do?’ breaks it all down for you.
  • Expense ratio

The best liquid funds

The whole process of evaluating all of the candidates to arrive at the best liquid funds, what with numerous moving parts to factor in, can be daunting. Here, we make it easier for you to make the best choice for your portfolio.

  • Prime MF Ratings  considers the risks with respect to debt funds, and will largely reflect the changing risk in any fund, on a quarterly basis. 
  • Our MF review toolcalls out funds in very short and short duration spaces that carry higher credit risk in the comments column.
  • Prime Funds, where we pick the best funds for you to consider, are picked only after considering the risk profile every quarter. Take a look to see the best liquid funds that we have identified.
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