Our five-step guide to choosing the right liquid mutual fund

Summary: When it comes to building your emergency corpus, liquid funds emerge as the go-to option. But how do you choose the right liquid fund? Here, we present to you a five-step checklist that guides you through the process of selecting a liquid fund suited to your needs.

Stashing your emergency fund in a savings account is perhaps the most straightforward, no-brainer method. But it's not the best.

Enter liquid funds; they do what a savings account does, but better. These funds match the safety of savings accounts and are easily accessible while offering higher returns.

They invest in short-term money market instruments such as treasury bills, certificates of deposit and commercial papers, which typically mature within 91 days, underscoring their safety and stability.

Since these funds also allow easy, quick redemption, they are ideal for meeting immediate, short-term financial needs.

With 37 liquid funds managing a massive corpus of Rs 5.3 lakh crore, there are many picks to choose from. How do you pick the right one? Here's a five-step guide to help you make an informed decision:

Step 1: Check the expense ratio

The expense ratio, a fee charged by the fund for managing your money, directly eats into your returns. The difference can be meaningful, especially in the case of large investments.

The average expense ratio of liquid funds is 0.15 per cent, ranging from as low as 0.07 per cent to up to 0.25 per cent. Opt for funds that charge competitively while still offering consistent performance.

Step 2: Assess the credit quality

Opt for funds that invest in instruments with high credit ratings, like those rated AAA or A1+, to minimise the risk of default. As of November 2024, 58 per cent of average liquid fund assets were invested in AAA-rated equivalent securities and 12 per cent in sovereign instruments, which are also risk-free. The rest was invested in cash and equivalents.

Step 3: Evaluate the fund size

Large funds benefit from economies of scale. Their larger asset base also enables them to spread investments across a broad spectrum of high-quality debt securities, minimising concentration risk. Small funds often lack this flexibility. Hence, mid-to-large-sized funds are ideal as they tend to manage liquidity efficiently and meet redemption demands without compromising on portfolio quality.

Step 4: Review historical volatility

Liquid funds are considered stable, but they are not immune to occasional dips. A major factor that can impact their returns is yield movements. While these instances are rare, reviewing how a fund performed during such periods can give you confidence in its stability.

Instances when liquid funds turned negative in the last five years

Step 5: Look beyond returns

The difference in returns among liquid funds is typically negligible. Their current annualised median return is 7.17 per cent.

Remember, the goal of a liquid fund is not to chase high returns but to preserve capital while providing easy liquidity. Hence, besides returns, pay attention to whether the fund has been a consistent performer or not while keeping the investments safe.

Find these parameters at a glance

Head to the category’s Fund Monitor section and find the above parameters for comparing liquid funds:

• Compare expense ratios to find cost-efficient funds.
• Review portfolio details to check credit quality.
• Look at historical performance for insights into trends and stability over time.

With these tools, you can confidently choose a fund that aligns with your goals. Happy investing!

Also read: Arbitrage funds vs liquid funds: Where to invest for the short term?

This article was originally published on January 01, 2025, and last updated on December 26, 2025.