Expert advice

Nov 06, 2013,14.22 IST

All you wanted to know about liquid funds

 

Hemant Rustagi
Wiseinvest Advisors

Every mutual fund scheme has an investment objective that specifies what it aims to achieve for its investors. The investment objective of a liquid scheme is to provide investors an opportunity to earn returns through investments in debt & money market securities such as treasury bills, certificate of deposits and commercial papers, without compromising the liquidity.

To ensure high degree of liquidity as well as to minimize the volatility, liquid funds invest in securities that have a residual maturity of less than or equal to 91 days. Since liquid funds have a low level of risk, they are assigned blue colour as per codes specified by the SEBI.

Considering that liquid funds are ideally suited for investments that may be required to be redeemed at a short notice, most of the funds in this category do not have any exit load. Even those funds that have an exit load, usually charge a nominal load for investments redeemed within a week or so.

Although liquid funds are a safe option for investors from the point of view of volatility and risk of losing capital, it is important to invest in them for the right time horizon so that one doesn’t suffer from opportunity loss.

For example, an investment in a liquid fund with a longer term horizon of say one year or more can result in an investor compromising his chances of earning higher returns through options such as short term income funds and FMPs.

Liquid funds score over traditional investment options like savings bank account and short term fixed deposits as they have the potential to provide higher returns.

However, one must choose the right option out of the ones offered by mutual funds like dividend payout, dividend re-investment and growth to enhance post tax returns.

It is important because being a debt fund by definition, a liquid fund is required to pay dividend distribution tax (DDT), before distributing dividends to investors. It is also important to mention here that most liquid funds offer only dividend reinvestment (daily, weekly and/or fortnightly) and growth option.

Some liquid funds do offer dividend payout options, but only for large investments on a weekly and fortnightly basis.

As per the current income tax laws, the DDT under the debt funds ( including liquid funds) for individual investors is 28.3250 percent ( 25 %+ 10% surcharge+3% cess).

However, for those who opt for growth option, short term capital gains i.e. capital gains earned out of investments sold within 12 months from the date of investment, are taxed at one’s applicable rate of taxation.

For example, an investor in 10 percent slab has to pay short term capital gains taxes@ 10 percent. It is quite evident that a growth option would be much more tax efficient for him as compared to dividend payout or dividend re-investment.

However, for investors in the highest tax slab of 30 percent, opting for dividend reinvestment would be more tax efficient.

Liquid funds also score over bank deposits because mutual funds do not deduct tax at source (TDS). It makes the process a little less tedious for all those investors who opt for growth option. On the other hand, since the DDT is paid by the fund, dividend received in the hands of investors is tax free.

Investors have a number of liquid funds to choose from. From performance point of view, there is not much differentiation between them.

However, for those who may like to analyze the performance of liquid funds, the right way would be to compare the performance with that of the benchmark as well as the peer group i.e. other funds in the same category.

Liquid funds usually have Crisil’s liquid fund index as the benchmark. Investors may have their own personal yardstick like the returns that they earn from savings bank account or short term FDs.

Despite having an edge over traditional investment options, the retail participation in liquid funds is still very low. That’s because they find putting money into savings bank account much more convenient.

Besides, lack of awareness about liquid funds also makes investors vary of investing in these funds. Many investors tend to keep a sizeable balance in their savings bank accounts, and that too for prolonged periods.

It’s time for them to turn their attention to short term investments too and embrace options like liquid funds to enhance returns. Remember, liquid funds can make a significant difference to what you get to keep in the end. 

The author is the CEO of Wiseinvest Advisors.

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