What are liquid funds and how do they work?

Mutual fund schemes come in different types. There are top equity funds which invest primarily in equities and then there are debt funds which invest primarily in debt securities. You, therefore, have a choice of investing in any type of mutual fund scheme as per your investment strategy and risk profile. Among the different types of mutual fund schemes available, a liquid fund is the most suitable fund if you want to park your surplus funds for a short term period. Let’s understand what liquid funds are and how they work –

What is a liquid mutual fund?

A liquid mutual fund is a short term debt mutual fund. The fund invests primarily in debt instruments with a short-term maturity period. A liquid fund is also called an ultra-short-term or short term debt fund which is suitable for investors looking for short-term investments.

How do liquid funds work?

When you invest in a liquid mutual fund, the money is pooled into a corpus. Other investors’ investments are also pooled in a corpus and the pooled corpus is then invested by experienced fund managers. These fund managers allocate the pooled investments into different types of debt instruments which have a maturity period of up to 91 days. The instruments usually held by a liquid fund’s portfolio include treasury bills, certificates of deposits, call money, term deposits, money market instruments, etc. As the portfolio provides returns the NAV of the liquid fund increases thereby giving returns to investors.

Benefits of liquid mutual funds

Here are some common benefits of liquid mutual funds –

• Since the maturity period of the underlying assets of the fund’s portfolio is up to 91 days, liquid mutual funds provide easy liquidity to investors

• If you need to park your surplus funds, for the time being, liquid mutual funds are the ideal investment avenue which also gives returns besides easy liquidity

• Returns offered by liquid mutual funds lie in the range of 6%% to 9%. Thus, these schemes provide better returns than bank saving accounts and can be used to earn better returns on the parked surplus cash

• Since liquid funds are debt oriented mutual funds, they have low investment risk. Liquid funds are not as threatened by market volatility as top equity funds. Thus, in the time of falling markets, you can switch your equity investments to liquid funds to escape market volatility and still earn returns.

• Liquid funds allow instant redemptions wherein you can redeem the fund and get liquid cash in your bank account overnight

• There is no exit load applicable in liquid funds making it easy for you to exit from the scheme as and when you want

Taxation of liquid funds

Here are the tax implications of investing in liquid mutual fund schemes –

• Investment into the scheme does not allow any tax benefits. The investment is done from your taxable income.

• If you opt for a dividend-oriented liquid fund, the dividend received would be taxed in your hands at your income tax slab rates

• Returns earned from liquid mutual funds are taxed based on the time for which you remained invested. If you redeem the fund within 36 months of investment, it would be called a short term capital gain. This short term capital gain would be taxed at your income tax slab rate. If, however, you redeem the funds after 36 months of investment, the returns generated would be called long term capital gains. Long term capital gains would be taxed @20% along with the benefit of indexation. This benefit of indexation allows you to factor in inflation in the returns earned and lowers your tax liability.

Best liquid funds

Though there are multiple liquid mutual funds available in the market, here are the five best liquid funds for you to choose from –

So, if you want to invest your surplus money for a short period, choose the best liquid funds. The returns would be good and you can even redeem your money instantly whenever you want.