Liquid Funds: Invest

November 14, 2012 . Vidya Bala

Ideal Parking Grounds for your Surplus

Do you have surplus money in hand but don’t wish to lock them in fixed deposits? Then, instead of holding huge sums in your savings bank, you can explore options such as liquid funds.

In the current high interest rate scenario, if you wish your money to earn a bit while you hold them, then liquid funds can do a better job than savings account. The average return of liquid funds in the last one year was 9.3 per cent. That is as much as fixed deposit rates.

What they are

Liquid funds are simply debt mutual funds that invest your money in very short-term market instruments such as treasury bills, government securities and call money that hold least amount of risk. These funds can invest in instruments up to a maturity of 91 days. The maturity is mostly much lower than that.

They are least risky as well as least volatile in the category of mutual funds for the following reason: one, mutual funds mostly invest in instruments with high credit rating (P1+). Two, unlike other funds, the NAV of liquid funds is not volatile as the only change in their NAV is mostly as a result of the interest income that accrues. In other words, given their short-term maturities, these instruments are hardly traded in the market. They are held until maturity. Hence, their NAV only sees a change to the extent of interest income accrued, everyday, including weekends.

Differ from ultra-short-term funds

Another category of short-term debt fund called the ultra short-term fund is also suitable for short-term investing. But these are one notch higher on the risk chart compared with liquid funds. This is because ultra-short-term funds can invest in short-term instruments that have a maturity of over three months. These instruments may also be traded in the market. Hence, the NAV may swing in response to market movements, making it a little more volatile.

Two other key differences between liquid funds and ultra short-term funds are the exit load and dividend distribution tax (DDT). Liquid funds do not suffer exit load while a few ultra-short-term funds may levy them for exits made immediately after investment (time for exit may vary between funds). Liquid funds suffer DDT of 27.04 per cent (deducted at the AMC end, including surcharge and cess) but for ultra-short term funds it is only 13.52 per cent.

When to opt

Liquid funds are ideal parking grounds when you have a sudden influx of cash either because you have received money from any legal settlement or from maturity of investments. It is noteworthy that liquid funds cannot be a full-fledged substitute for a savings bank account. Barring some funds, you cannot withdraw money instantly (like you do with an ATM).

That said, given the low interest rates (about 4 per cent mostly and 6-7 per cent in the case of one or two banks) in savings account, you would do well to temporarily put your money in liquid funds to earn slightly higher interest. You can exit the scheme anytime without any exit load and receive your funds the next day.

Another way to make use of liquid funds is invest your lump sum receipts in them and then opt for a systematic transfer plan to invest in equity funds of your choice. Often, you would use SIPs to invest in equity funds. That is fine when you invest out of your monthly savings. But if you receive a large sum at one go, you can use liquid funds in such instances, to enhance your returns.

If your holding period is much higher than three months – say 6-9 months or more – then you can consider going for ultra-short term funds. Invest in these funds in one go as you need not worry about timing the market. Not all liquid funds will have SIPs options.

How to be tax efficient

You may view liquid funds as inefficient tax vehicles as they suffer from short-term capital gains tax (at your regular tax slab) if held for less than a year. Hence, if you are in the high tax bracket, this does hurt. But there is a more efficient strategy to handle this.

Consider opting for dividend reinvestment. The dividends stripped will be reinvested as units. These will be considered as fresh investments. With a low NAV stripped off dividend and reinvested units considered as fresh cost, your capital gain (sale-cost) will be almost nil or very low.

But if you are holding liquid or ultra short funds for over a year, then, you may well opt for growth option as you will get indexation benefits.


We have given a list of liquid funds that have done well in the recent years. This list is based on the funds’ low expense ratio, consistent average returns of over 7 per cent and a portfolio that has least maturity (to ensure low volatility). But it is noteworthy that the returns earned in the past couple of years may not be replicated, once interest rates fall. Yet, they may yield better than savings bank rate.


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