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Liquid logic

Is it finally time for individual investors say goodbye to liquid funds forever?

Liquid logic

Are liquid funds unsuitable for us individuals? Is it logical to extend such doubts to other types of fixed-income funds? No matter what the answer is, the time may have come to ask such questions seriously. All this angst has been triggered by a spate of unexpected problems that liquid-fund investors have experienced.

Over the past few months, liquid funds have been in turmoil, with investors developing a strong fear of potential losses where they had once expected none. Liquid funds are useful for one narrow purpose only, which is to keep money for very short periods of time with a very high degree of safety. Essentially, liquid funds are substitutes for keeping money in the bank but have slightly higher returns. One would suppose that this substitution should generally be too much trouble for those of us who keep a few thousand to a few lakh rupees in the bank, but it would matter a lot to larger businesses. However, even so, there are plenty of individuals as well as small businesses that are using liquid funds to park cash.

The problem is that investors expect -and have been led to expect - that their will be no negative surprises in these funds and each day's NAV will be more or less as predicted by the prevailing rates. However, as every fixed-income investor knows by now, in the recent past, there have been some cases where debt issued by a particular company has suddenly turned toxic, with IL&FS being the latest and biggest case. Inevitably, there were liquid funds that lost value and investors panicked.

There are regulatory changes that are in the process to improve the structure of liquid funds and that's one part of it. 'Side-pocketing' as well as a change in valuation norms both appear to be on the anvil. These should be operational before long and will certainly give investors a better deal when there are any issues in any underlying investment. However, we are still left with the original question that investors are asking, which is, "In practical terms, are liquid funds completely safe?" As an answer, one must say that almost but not quite. If you are looking for perfect safety, then there are no guarantees.

As an investor, the logical question that you would ask in response is what has changed now? Why is it that for the better part of two decades, one could take liquid funds as a surety but one can't do that now? The answer lies in the changing nature of Indian business as well as how the credit-rating agencies are failing to cope with those changes but that's a story for another day. Whatever be the causes, at the end of the day, liquid funds are probably not worthwhile for small investors as a substitute for bank deposits.

However, that definitely does not mean that fixed-income funds on the whole are unsuitable. Hybrid funds of various kinds, including equity savings funds, can play a crucial role in any individual's portfolio. And if one needs to have safe investments for periods of six months to two-three years (till which point, equity is not suitable), then short-duration debt funds are eminently suitable.

It's only for shorter periods that the recent experience has shown liquid funds to be unsuitable.