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Sep 21, 2011, 09.41 AM IST | Source: Moneycontrol.com

Liquid funds - an alternative to savings bank deposits

If you are looking for an alternative to savings bank deposits, then Liquid fund is just right for you. With higher post tax returns, liquid and reasonable degree of safety, Liquid funds works to be a good form to park money in comparison to Savings deposit.

Liquid funds - an alternative to savings bank deposits

Liquid funds are mutual funds that, by way of their investments into debt market securities, offer higher post-tax returns vis--vis savings bank accounts. Besides this, they also offer a reasonable degree of safety in terms of the principal invested and most importantly offer high liquidity. Retail investors who park their short term surplus funds in savings bank accounts for liquidity should be aware of the existence of this remunerative option. According to the Association of Mutual Funds in India (AMFI), of the Rs 1.8 trillion assets under management (AUM) in liquid funds as on July 2011, retail investors constituted less than a 1% share while the rest was held by high net-worth individuals, corporates, banks and financial institutions. On the other hand, the size of savings bank deposits has continued to grow despite yielding only a nominal rate of return. The quantum of money in savings bank accounts in scheduled commercial banks was Rs 13.77 trillion as on March 31, 2011.

Liquid funds vs similar options available from banks

Liquid funds are mutual fund schemes where the primary objective is to invest in debt instruments with maturities of less than 91 days, generating optimal returns while maintaining safety and high liquidity. Liquid funds primarily invest in money market instruments such as certificates of deposits (CDs), commercial papers (CPs) and government treasury bills. Such a portfolio helps liquid funds provide high liquidity to investors. Accordingly, redemption requests are processed within 24 hours.

Table 1: Comparison of savings deposit, fixed deposit and liquid funds

  Savings deposit Fixed deposit Liquid funds
Liquidity High Medium High
Annualised returns Up to 4% 5.0% - 1 0.0%* 6.04% - 8 .06%**
Minimum lock-in No Yes 1 day
Principal guarantee Guarantee of up to Rs 1 lakh Govt -backed Govt - backed
guarantee of up to Rs 1 lakh
No guarantee
Safety (to the principal amount) High High Medium
Penalty
(on early withdrawals)
No Yes No
Availability of cheque facility Yes No No
Tax 0-30 %^ 0 - 3 0%^ 25%^^ in dividend option 0 - 30%^ in growth option (<1 year investment) 10 or 20%@ in growth option (>1 year investment)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

* The interest rate varies with the tenor of the deposit
**1-year returns as on July  29, 2011 of CRISIL Mutual Fund Ranked schemes (for quarter ended June 30, 2011), ^ plus 3% cess, ^^ plus 5% surcharge and 3% cess
@ 10% without indexation or 20% with indexation whichever is lower plus 3% cess

Liquid funds, although not backed by any principal guarantee, are relatively safe instruments as the portfolios of liquid funds mostly comprise 'A1+' rated CPs and CDs (highest rating for these types of securities) with a maximum maturity of 91 days.

However, the marginally higher risk in liquid funds as compared to a savings deposit is compensated by superior returns of liquid funds (see Chart 1). Also, during periods of rising inflation, returns from a liquid fund were typically higher, thereby reducing the effect of inflation.

Click here to know the performance of Liquid funds

The tax advantage

There are two options of investing in a liquid fund: i) growth option and ii) dividend option. In the case of growth option, returns from liquid funds would attract short term capital gains if redeemed within a year (as per the investor's income tax bracket) and long term capital gains if redeemed after a year (10% without indexation and 20% with indexation plus cess). In the case of a dividend option, although dividends are tax-free in the hands of the investor, there is a dividend distribution tax (DDT), which is paid by the mutual fund house before the dividend is distributed to unit holders.

Post tax, liquid funds yield better returns vis--vis savings deposits, where the interest earned on the latter would be taxed based on an individual's tax slab. Investment in a fixed deposit would also attract tax on returns as per the investor's tax-bracket (maximum of 30% plus cess).

Table 2: 1-year returns across investment types (as of July 29, 2011)

 

Investment amount (Rs)

Indicative yield

Pre-tax returns (Rs)

Tax rate (highest)

Post-tax returns (Rs)

Post tax yield

Savings account

-

4.00%

4,000

30.90%

2,764

2.76%

Fixed deposits

100,000

7.75%*

7,750

30.90%

5,355

5.36%

Liquid fund Dividend

 

7.61%^

7,610

27.04%

5,552

5.55%

Liquid fund Growth

 

7.61%^

7,610

20.60%**

7,610@

7.61%

 

 

 

 

 

 

 

 

 

 

*State Bank of India fixed deposit rate for 241 days to less than 1 year
^ 1-year returns of CRISIL Fund Rank 1 Liquid Funds
** Assuming an investment of 1 year and 1 day, @ Indexation benefits have resulted in nil tax

Choosing a liquid fund

Choosing an appropriate liquid fund can be a challenge as there are more than 40 funds offered by various fund houses. Further, most liquid funds have very little differentiation. The variation in returns between the best performing and worst performing scheme is almost 2% on an annualised basis. Hence, it is important for investors to assess the various schemes before investing. Alternatively, investors may refer to CRISIL's quarterly Mutual Fund Ranking which uses various net asset value and portfolio attributes to rank liquid funds.

Conclusion

Liquid fund is an alternate investment avenue for individuals to park their short term surplus funds. While bank deposits (fixed and savings) are easier to access and offer some degree of principal protection, the higher yield combined with the liquidity and taxation benefits make liquid funds an attractive option. However, liquid funds are not risk-free, and an investor must carry out basic checks before investing. Further, investors must spread their savings across fixed deposits, savings bank account and liquid funds, thereby enjoying the benefits each of these avenues have to offer.

 

Q The first non-UTI mutual fund was started by:

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