Liquid mutual funds are superior than other saving options. They offer higher returns, are affordable, convenient & highly liquid. But they are not 100% safe. This raises an important question for investors – ‘Should You Invest in Liquid Mutual Funds?’.
Let us look at the 8 reasons why you should invest in liquid funds.
Great for Portfolio Diversification: Investors often underestimate the importance of liquid assets in their portfolio. By investing in liquid funds, your other assets get ample time to grow.
Since any emergencies can be taken care of by liquid funds without premature redemption from other assets. Hence you should invest in liquid funds to diversify your portfolio.
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To Earn Superior Returns: Investors still prefer bank deposits despite them providing poor inflation-adjusted returns. The returns generated by Bank FDs will not help you beat the inflation.
For example: Suppose your bank FD gives you 6% annual return. But the inflation rate in the country is 6.5%. So, in reality you have earned a negative 0.5%!
In case of liquid funds, even if you earn 7% returns, you still beat inflation. Hence, you should invest in liquid funds to get superior returns.
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To Park Surplus Short-Term Cash: Often we are left with surplus cash. But we don’t know how to use it productively. And hence the cash stays idle in our bank savings account. There is earns 3.5% interest pre-tax. Post-tax your income is only 1.75%!
But when you invest in liquid funds, you have a chance to earn between 6.5% - 7.5% pre-tax return. So, post-tax, you end up making 4.16% - 4.80% - much higher than 1.75%!
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To Build Emergency / Contingency Fund: Every household must maintain 6-12 months of mandatory expenses as contingency fund. Majority of investors park 100% of their contingency fund in bank FDs. But this beats the purpose of a ‘emergency’ fund as premature withdrawal from FDs includes a high penalty.
A contingency fund must have high liquidity and convenience. Liquid funds are highly liquid and they can be redeemed within 24 hours. Hence, you should invest in liquid funds to build your contingency fund.
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For Short term Financial Goals: You should invest in liquid funds for short term financial goals such as vacation, car purchase, house down payment etc.
When your goals are of 3 months, then liquid funds are the perfect option. For goals in less than 1 month, investors should invest in overnight funds.
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To Facilitate Systematic Investment Plans (STPs): Majority of retail investors do not have the expertise to time the market.
So, what should they do we they receive lumpsum amount? Keeping it in savings account will not generate inflation beating returns! In such cases, investors can invest in equity funds through Systematic Transfer Plans (STPs).
In an STP, a lumpsum amount is invested in liquid funds. From there a fixed amount is invested in equity funds on a monthly basis.
By registering an STP, investors get dual benefit:
- Cost-averaging by investing in tranches in equity funds.
- Higher returns on liquid fund balance.
So, whenever you want to systematically invest in equity funds, then you should first invest in liquid funds and then register a STP.
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To get Liquidity Post Retirement: Generally, investment options available for retirees or senior citizens carry long investment tenure. Senior Citizen Savings Scheme (SCSS), Post Office Monthly Income Plan (POMIS), etc all have a more than 5-year lock-in period. In such cases, retirees and senior citizens do not have liquidity options. Hence senior citizens and retirees should invest in liquid fund for emergencies.
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Best Investment Option for Low-Risk Investors: Debt funds are often advertised as suitable for low-risk investors. But not all debt funds carry low risk. Credit risk funds, dynamic bond funds etc carry high risk. These funds are not suitable for low-risk investors. Hence the best option for low-risk investors with short term financial goals, is to invest in liquid funds with AAA rates papers only.
Now that we understand why you should invest in liquid funds, let us also look at the things you need to consider before investing in liquid funds.
6 Things to Consider Before Investing in Liquid Funds
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Financial Goals: Investing without financial goals is never a good idea. You should fist ascertain your financial goals and then invest. Your financial goals should be SMART – Specific, Measurable, Attainable, Realistic and Time Bound.
For example: If your financial goal is in the next 2 months, then you should invest in liquid funds. But if your financial goals are 5 years down the line, then corporate bond funds or Banking & PSU Debt Funds will be more suited to you.
Investment Horizon: Investment horizon helps you decide which type of fund to invest in. For example: If your investment horizon is less than 30 days, then you should invest in overnight funds. For investment horizon of more than 6 months, ultra short term or money market funds are apt. So, ideally you should match your investment horizon with the fund’s average maturity.
Risk Profile: Deciding what kind of risk you are willing to take is very important before investing in liquid funds. Some liquid funds with higher exposure to private papers carry higher risk and might not be suitable for low-risk investors. Hence investors should match their risk tolerance with the funds risk profile.
Expense Ratio: There is an indirect relationship between expense ratios and returns. Higher the expense ratio, lower the returns. Since liquid funds offer lower returns than other debt mutual funds, you should try to invest in liquid mutual funds with lower expense ratios. This will help you gain a little extra from your liquid fund.
Paper Quality: While investing in liquid fund, you should always check the paper quality. AAA rated papers are highly stable. D rated papers are Junk. Ideally you should invest in liquid funds with maximum allocation to AAA rated papers. To be extremely safe, you should invest in papers issued by the government.
Fund Performance: While selecting liquid funds, you should also consider the past performance of the fund. You should check whether its risk-adjusted returns like Sharpe, Treynor, Standard Deviation, Alpha etc are in line with the benchmark. Ideally you should invest in liquid funds which have consistently beaten the benchmark.
While looking at past performance is important, past performance does not guarantee future performance. You need to study the quality of the underlying papers of a liquid fund. For this, you need to evaluate more than 20 million data points.
We understand that such high-end evaluation is not possible for retail investors. Hence, RankMF evaluates and ranks all the liquid mutual funds in India. RankMF, after processing more than 20 million data pointers, has discovered the best liquid funds in India for 2021.
You can explore our list of best liquid funds for 2021 for FREE by opening a FREE RankMF account today!
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