Liquid funds are meant to provide high liquidity to investors by investing in money market investments. They are short-term investment vehicles for those with a short or uncertain investment horizon who wish to earn interest on their cash balances rather than leave them idle.

Where they invest Indian liquid funds typically invest in highly liquid money market instruments with a maximum residual maturity of 90 days. These include commercial papers, certificates of deposit, treasury bills, short-term debentures, fixed deposits and other allied instruments. Most liquid funds have low expense structures in order to pass on maximum benefit to investors.

Returns picture Since the investments are in very short-duration assets, liquid fund returns tend to be relatively more stable than of other debt funds. Their returns are directly linked to overnight rates such as the repo and MIBOR, which are highly reactive to monetary policy rate actions and market liquidity conditions.

Hence, a rate hike can lead to increased returns in liquid funds since the yields in the market also harden.

Since overnight rates usually tend to tighten at quarter ends (when tax money flows out of the system), it may be worthwhile for investors to time their investments such that they gain from the increase in yields of short-term assets at the time the quarter ends, provided the liquid fund they choose is geared to take advantage of such a tightening.

Liquid funds have gained popularity on account of the advantages they offer over investments, such as current accounts or fixed deposits. For one, liquid funds provide investors with overnight liquidity (that is, money invested today may be withdrawn the next day). Two, they give returns that are usually in excess of the overnight rates which are available to financial institutions. This combination of high return and overnight liquidity is not readily available in most other asset classes.

Almost all mutual funds in India have liquid funds and this leads to considerable competition amongst fund houses.

While choosing amongst liquid funds, pay attention to the fund’s portfolio quality. Investments in poor-quality assets or illiquid securities can be disastrous for liquid fund investors.

In addition, fund size, track record and pedigree of the fund house also play a part in the selection process, amongst investors.

The author is Senior Fund Manager-Debt, LIC Nomura Mutual Fund

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