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 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
* The interest rate varies with the tenor of the deposit
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.
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-ŕ-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)
*State Bank of India fixed deposit rate for 241 days to less than 1 year
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.
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.
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