You may come across emergencies which warrant sudden requirement of cash. In such a situation, mutual funds come in handy.
What is liquidity for investing context?
Liquidity reflects the ease with which an investor may turn an asset into cash without incurring any fall in its value. In a way, it relates to ability of an asset to be converted into cash during a purchase or sale transaction without adversely influencing its price. From an investment perspective, liquidity defines the convenience with which an asset can be purchased or sold to fulfill emergency cash requirements. Amongst various asset classes available, cash has the highest liquidity. Apart from that, highly-traded stocks also fall in the category of liquid assets because you may find takers of these stocks very easily and sell them conveniently to receive cash.
Assets like real estate and thinly-traded stocks may become difficult to liquidate during an economic crisis without losing a great deal of money. With respect to mutual funds, you may expect a great deal of flexibility and liquidity coupled with higher returns.
Why liquidity matters?
While assessing an investment product, most of the investors keep rate of return as a selection parameter. There is excessive importance given to performance of the underlying asset. However, not much emphasis is given to liquidity of the product. Basically, any kind of investment is done to achieve a given set of goals. You keep contributing towards the product with an intention to receive the accumulated corpus when the goal becomes due. But if you are not able to exit the product at the right time, then it might have serious repercussions. Especially, in case of market-related products like equity funds, an unplanned delay may lead to erosion in fund value when you are unable to redeem on time.
So, at the time of asset allocation, you need to keep the liquidity aspect in mind and choose the products accordingly. You might have witnessed that certain illiquid assets offer exceptionally high rate of return. However, you need to approach this from a holistic point of view. It is agreeable that liquidity and profitability are conflicting considerations. But you need to provide for liquidity while keeping profitability in mind.
Mutual funds offer a combination of liquidity and profitability packed under same scheme. Except Equity-Linked Saving Scheme (ELSS) which comes with a lock-in of 3 years, all the other open-ended equity funds are highly liquid. You can redeem the units via the buyback option and get the amount credited in your bank account. In case of Exchange-Traded Funds (ETFs), you get the real-time NAVs and the redemption facility of either buyback or selling the units in the stock exchange just like equity shares.
How liquidity in mutual funds is beneficial?
Being market-linked products, the liquidity offered by mutual funds can prove to be a boon for the investors in many ways.
== In cases where a fund or a group of funds have consistently underperformed the benchmark across time intervals, you may use your liquidity option to redeem the said fund and switch to a superior fund.
== There is always going to be a time lag between your investing in mutual funds and the date when your goal becomes due. In between these two data point, market may change owing to dynamic economic events. In such a scenario, liquidity offered by mutual funds helps you to review the relevance of the given funds keeping the changed scenario in mind. Based on such an analysis, you may rebalance your portfolio accordingly to keep your risk profile intact.
== Some long-term goals like retirement planning require you to make an exit at an appropriate time to optimise on market volatility. Mutual funds offer the facility of Systematic Transfer Plan (STP) and Systematic Withdrawal Plan (SWP) for this purpose. STP help you to transfer funds from high-risk haven like equity funds to low-risk havens like debt funds as you approach retirement. SWPs help to redeem the fund in a phased manner to avoid any jerks.
== You may come across emergencies which warrant sudden requirement of cash. In such a situation, mutual funds come in handy. You may create a highly-liquid emergency fund known as Liquid Fund for this purpose. It is a type of debt fund which gives higher returns than a regular saving bank account. It offers flexibility to withdraw money any time without incurring any exit loads. You may think of putting your six months’ worth of personal expenses in a liquid fund for your emergency needs.
Mutual funds are indeed sophisticated products. Liquidity is definitely an important parameter but not the only selection criteria. Your investing decisions need to be goal-driven and as per your risk tolerance.The writer is Founder & CEO ClearTaxNot sure which mutual funds to buy? Download moneycontrol transact app to get personalised investment recommendations.