Advantages and disadvantages of liquid funds

In the ever-changing world of finance, there is no shortage of investment options. With each passing day, innovative financial instruments are being introduced to meet the diverse needs of investors, helping them grow their wealth and achieve their financial goals. Among these, liquid funds have emerged as an ideal alternative for investors seeking short-term financial gains without compromising their liquidity.

These funds invest in high-quality debt and money market instruments such as commercial paper, treasury bills, government securities, and certificates of deposits that mature within 91 days. But like all investments, liquid funds have their pros and cons that you must weigh before allocating your hard-earned money to them.

Advantages of investing in liquid funds

• Easy redemption

You can redeem up to Rs 50,000 per day per scheme per investor through the instant redemption facility offered by liquid funds, making them ideal for maintaining an emergency fund.  

• Invest in other schemes via an STP or a systematic transfer plan

Through a systematic transfer plan, liquid funds provide a low-risk solution to making regular investments into more volatile equity schemes. Rather than having to time the markets and predict the right time to invest in equity schemes, simply set up an STP through liquid funds and invest systematically with small contributions. This allows you to enjoy both higher returns on your liquid fund balance as well as capital appreciation through equity investment. 

• Low-risk investment

Liquid funds are considered low-risk investments since they tend to be invested in relatively safe debt instruments. Also, the short maturity period helps mitigate risk since these funds do not remain exposed to the markets for long periods of time. 

• No exit load from 7th day

With no exit load applicable if the units are held beyond seven days, liquid mutual funds offer the opportunity to invest without worrying about high penalties on withdrawals. Furthermore, you can select different dividend payout options, such as daily, weekly, or monthly, as per your financial goals, amount invested, and investment period. 

Risk associated with liquid funds

• Interest rate risk

While liquid fund investment generally carries short maturities, making them less vulnerable to fluctuations in interest rates, they are not completely risk-free. If there is a substantial fluctuation in interest rates, the total value of your investment may be affected. 

• Credit risk

It refers to the potential inability of the fund’s issuer to fulfil their debt obligations. When bond issuers fail to repay the principal or interest on time, investors could be exposed to a loss in their investment’s value. 

• Taxation 

Short-term capital gains in these mutual fund schemes are subject to taxation according to your applicable tax slabs. Those in the highest tax bracket, hence, end up paying higher taxes on their short-term gains as compared to those falling under lower slabs. 

Look into long-term capital gains options where you can benefit from indexation benefits which reduce your overall tax burden significantly over time. SIPs in liquid funds can be used for this purpose. However, make sure to use an SIP calculator beforehand to get much clarity about your projected returns and amounts that need to be set aside regularly for investment. 

Final words

You can use liquid funds to park your large corpus temporarily, maintain an emergency fund, or for other short-term goals. Moreover, digital platforms and mutual fund investment apps make it easy to invest and track performance in real-time. However, remember to focus on factors such as fund objective, credit quality, past performance, and expense ratio when investing. Having this information can guide your decision-making and help ensure that your investment strategy matches your goals and risk appetite.