Wondering whether to invest in a liquid fund instead of squirreling away your excess cash in a tried-and-true savings account? The other week, we chanced on a conversation between two friends pitting the pros and cons of liquid funds against savings bank accounts. Here’s recounting their discussion to help you make a decision:

Asha: Did you invest some of that pile of cash in your savings bank account in a liquid fund, as I suggested?

Ravi: Not yet. You did not explain what a liquid fund is and how risky it is. Was thinking I already have a systematic investment strategy going on that draws money out of my bank account every month. So, I can afford to leave my money in my bank account!

Asha: Fine then, here goes. A liquid fund is a debt mutual fund that invests in very short-term instruments — commercial papers, treasury bills, certificates of deposit, and so on. Liquid funds generally invest in instruments that have a very high credit rating.

The maturity of the instrument can go up to 91 days. But portfolios of most liquid funds have average maturities well below that; even six or eight days sometimes. So a liquid fund holds very low risk.

Ravi: How so?

Asha: Patience! I’m coming to that. Since the instruments have very short tenures, they are not traded in the market, and instead held-to-maturity by the fund. This removes mark-to-market losses on the instruments and eliminates volatility. Other debt funds have securities with longer maturities and so are more influenced by interest rate changes and market movement.

Ravi: How does the net asset value move then and how do we make any returns?

Asha: A change in the net asset value of a liquid fund comes about as interest on the instrument accrues. In the past one year, liquid funds have given an average 9 per cent return.

Top performers have even delivered 10 per cent. Most banks pay annual rates of 4 per cent on savings accounts, though some pay 5.5-7 per cent. Liquid funds also give dividends, ranging from daily to quarterly payouts.

Ravi: But I can withdraw money from my bank at any time. Plus, funds charge exit loads on early redemption. So why would I choose liquid funds?

Asha: Yes, you cannot draw money from a liquid fund as you would from an ATM, except with maybe one or two funds. So yes, a bank account definitely scores highest on liquidity.

But since liquid funds have low average maturities, they can be redeemed easily without suffering losses. And these funds don’t have any exit loads!

Expenses in a liquid fund are usually less than 1 per cent.

Ravi: But funds can incur losses. A savings bank account is very safe.

Asha: No, liquid funds very rarely deliver capital losses, because of the low risk I just explained. There may be one-time instances, such as last July, when liquid funds did slip. Even in such cases, don’t panic and sell. Instead, allow the benefit of holding the instrument till maturity to come into play.

Ravi: What about taxes?

Asha: Liquid funds are subject to dividend distribution tax of 28.325 per cent, which the fund house pays. When you sell a liquid fund, it attracts short-term capital gains tax at your income tax slab rate if the holding period is less than one year.

Long-term capital gains tax at 20 per cent with indexation and 10 per cent without applies to holding periods over one year. Interest above Rs 10,000 in a year from your savings bank account is subject to tax according to your slab.

Ravi: So which has better post-tax returns?

Asha: Liquid funds give higher returns than savings bank accounts even on a post-tax basis. Across interest rate cycles in the past five years, liquid fund returns have held above the savings bank rate.

Ravi: All this talk, and I’m still not clear on when to use liquid funds!

Asha: All right, let me spell it out. If there’s a large sum in your bank account lying idle, then a liquid fund is a good parking ground.

Part of your ‘emergency’ cash pile can be invested here too. Also, say you’ve got a sudden inflow of money. You can temporarily put it in a liquid fund and earn good returns until you work out how to invest it.

> bhavana.acharya@thehindu.co.in

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