Cash On Call

An investment is declared as liquid or illiquid depending on its ability to get converted into cash without a significant loss in value. Liquid funds get their name from this trait and hence are a good avenue to park short-term money.

While liquid funds were broadly referred to as debt funds with low maturity paper, an unambiguous definition of this category only emerged clearly from January 2009. That was the time the Securities and Exchange Board of India (SEBI) mandated that these funds would only invest in securities with maturity not exceeding 91 days. Currently, the average portfolio maturity of this category ranges between four and 91 days.

While liquidity is one factor of these funds, another is the safety aspect. The low maturity makes them relatively less sensitive to interest rate fluctuations, as compared to other debt funds. Hence low risk is another factor that works well in their favour.

Besides liquidity and risk, one should always consider the tax aspect of an investment. It is this that adds to the attractiveness of the investment from a corporate point of view. For one, long-term capital gains are taxed at a rate of 20 per cent without indexation and 10 per cent with indexation. The dividend from these funds is taxed at the rate of 25 per cent plus 10 per cent surcharge plus 3 per cent education cess. While the surcharge and education cess stays the same, corporates pay tax at the rate of 30 per cent. To enable investors get the maximum benefit, most funds have a weekly or even daily dividend option. Having said that, the tax arbitrage will no longer be in existence from June 2011 for corporate investors. In the recent Budget of February 2011, the tax on dividend distributed by liquid funds was increased to 30 per cent for corporates while it remains the same for individual investors.

The corporate impact
The track record of these funds makes them ideal stops for parking short-term money at virtually no risk. For instance, if you need to buy a house and would require a down payment of Rs20 lakh two months down the road, you can put the money in a liquid fund. It will earn you a return which would be higher than what you would get in a savings bank account (4% per annum) or probably even a two-month fixed deposit.
Nevertheless, investments by retail investors account for a very small portion of the assets of liquid funds. Investors still prefer parking their money in a savings account and have not been accustomed to a liquid fund as an alternative. Also, since the return is not high when compared to other investments, the return on small amounts of money does not incentivize investors.
However, these funds are widely used by institutional investors and corporates to park their short term funds. They use such schemes as a current account where they can withdraw and deposit money as and when they want in varying amounts. But unlike a current account, they earn a return on the money parked. So cash that needs to be put away and accessed for certain periodic payments such as advance tax at the end of every quarter and service tax every month, such a fund comes in handy. As the quantum of money parked by corporates is high, the gains become substantial in absolute terms when compared to what a retail investor would earn on his investment.
If corporates employ such funds to park their money, it is obvious that assets will fluctuate a lot. And data bears this out. In March 2011, liquid funds showed inflows of Rs6.16 lakh crore while Rs7.15 lakh crore was the outflow. The category witnessed the highest net outflow of Rs98,255 crore. The assets under management (AUM) on March 31, 2011 were just Rs0.74 lakh crore. This indicates that huge sums of money come into these funds for a short tenure and is basically money on call.
Generally, liquid funds see negative flows at the end of every quarter due to payment of advance tax. When we looked at data over the past five years, every quarter ending month (barring a few) has seen a net outflow from these funds. While inflows and outflows depend on a variety of issues, including interest rates, the new Reserve Bank of India (RBI) directive to cap bank investments in liquid mutual funds will definitely ensure that the AUM of this category won’t be growing by leaps and bounds anymore.
An unfortunate development has been the dependency on fund houses on liquid schemes to increase their asset base. In a bid to woo institutional players, funds came out with separate institutional plans in liquid schemes, which had a much lower expense ratio than the retail plan. At times, some of the funds were seen changing the expenses ratios frequently to benefit a few big ticket investors.
The zooming size of liquid funds and the increasing dependency on small number of institutional investors aggravated the crisis of 2008 but did bring to the forefront the loopholes in these funds.

Post 2008
With no regard for risk, liquid funds were rampantly increasing maturity and chasing returns. In 2008, this category delivered a return of close to 9 per cent and the best performing fund (LICMF Floating Rate ST) delivered around 10 per cent.
But in October 2008, under extremely tight liquidity conditions, the unexpected happened. The tight liquidity combined with a loss of confidence led investors to aggressively pull out money. Liquid funds have always seen wide fluctuations in assets but in a very predictable fashion. It was not rare to see a fund’s assets decline by 30-40 per cent in a month and similarly increase by the same amount later.
The sudden pull out took the funds by surprise and since the holdings were not liquid there was a problem. The paper in the portfolios were of higher maturity and there was also a mismatch between the actual realizable price and the price at which they were valued by the asset management companies (AMCs). The AMCs had to cater to the redemption at net asset value (NAV) and were unable to realise the price at which the instruments were valued by them. Some of the liquid funds also returned negative daily returns for the first time. All the three plans of Mirae Asset Liquid Fund - Retail, Institutional and Super Institutional posted negative daily returns in October 2010.
The crisis brought to the limelight the loopholes in liquid funds and SEBI moved rapidly to ensure that there would not be a repeat occurrence.
Portfolio maturity: On January 19, 2009, liquid funds were ordered to reduce their maximum maturity to six months by February 1 and further to three months by May 1, 2009. Mind you, these are the maximum maturities of any paper, not the average of the overall portfolio. With this in place, fund managers were then unable to find any room to generate extra returns in liquid funds. And that’s how it should be.
Concentration risk: Since April 2009, no mutual fund scheme is allowed to invest more than 30 per cent of its net assets in money market instruments of a single issuer. The schemes may, however, continue to invest up to 15-20 per cent of net assets, as the case may be, in other investment grade debt instruments of an issuer as already provided in the regulations. These limits will not cover investments in Government Securities, T-Bills and Collateralized Borrowing and Lending Obligations.
Valuation of instruments: In 2008, the mismatch in the price at which the mutual funds valued their debt portfolio and their actual market price led to some of the funds delivering negative returns. When mutual funds tried to sell securities to meet the redemption requirements, due to the lack of an active debt market, the price at which mutual funds valued their securities was much higher than the actual price they realised on selling the securities. But as the fund houses had to redeem the units at NAV, the remaining investors bore the burnt.
SEBI brought in rules to standardise the process of valuation of debt securities and changed it to reflect the market price. All money market and debt securities, including floating rate securities, with residual maturity of up to 91 days are now valued at the weighted average price at which they are traded on the particular valuation day.
When such securities are not traded on a particular valuation day they shall be valued on amortization basis. It is further clarified that in the case of floating rate securities with floor and caps on coupon rate and residual maturity of up to 91 days then those shall be valued on an amortization basis taking the coupon rate as floor.
Availability of funds before the cut-off time: Mutual funds would allot units to investors without even receiving the full amount, in expectation that the money will come later during the day. This made them entitled to the gains of that day or that period despite the fact that their money was never deployed. They were basically eating away the gains of other investors.
In November 2010, SEBI mandated that funds should be available for utilisation before the cut-off time without availing any credit facility, whether intra-day or otherwise, by the respective liquid schemes.
SEBI also increased the cut-off time for the applicability of NAV from 12 noon to 2 pm. If the application is received before 2 pm on a day and funds are available for utilization before the cut-off time without availing any credit facility, whether, intra-day or otherwise, the NAV of purchase would be that of the day immediately preceding the day of receipt of application, or else the price of the units would be the closing NAV of the day of the application.

Safe but not too lucrative
Now liquid funds are a completely changed product from what they were prior to 2008. The series of regulations brought in by SEBI has made them much safer and transparent and returned them to their proper role as relatively safe parking spots for short-term cash. However, the trade off has been with returns. In 2009 and 2010, these funds delivered 4.67 and 4.69 per cent, respectively.
Although there was a significant drop in the assets of liquid funds in 2010, they have again picked up. As on March 31, 2011, with assets under management of Rs1,66,203 crore, it is still the biggest category of mutual funds. The four largest mutual funds in India are from this category, ICICI Prudential Liquid Super Inst topping the list with net assets of Rs18,748 crore.