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What are liquid funds?

If you are new to the world of debt mutual funds, here's what you need to know about the liquid fund category


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Instead of parking your cash in a savings bank, why not put it where it fetches higher returns? A liquid fund is such an option. The risk in it is minimal, though not completely absent. Here's how to make the most of a liquid fund.

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What is it?
A liquid fund is a debt mutual fund scheme. You use it if you have excess cash and think you might need the cash in a few days or weeks or months. If you wish to invest a large sum in an equity fund, but want to stagger the investments over a period, put your money in a liquid fund and enrol for a systematic transfer plan (STP) whereby you invest a fixed sum from your liquid fund to an equity fund each month.

Returns and Risks
Your liquid fund, like every other mutual fund scheme, invests in securities that have a market price. When market price of these securities moves up or down, so does your mutual fund's net asset value (NAV). But a liquid fund's NAV doesn't move up or down as much as other funds.

Here's why. As per rules laid down by the capital market regulator, Securities and Exchange Board of India (Sebi), if a security matures in under 60 days, it need not be marked to market. Just the interest component needs to be added. In simple words, whatever interest your debt fund earns through the tenure of a security, it will divide the total interest component equally for the number of days it holds the security. The security's price remains steady. Hence, your liquid fund's NAV movement is linear; think of it as a steady line going up.

Does this mean your liquid funds are risk-free? No. Your liquid fund can invest in scrips that mature up to 91 days. Therefore, if it invests in scrips that mature between 60 and 91 days, it needs to mark-to-market the same, depending on its credit rating. To keep things simple, if such an underlying company defaults on its interest and/or principal repayment, the scrip's credit rating drops and so does its market price. If your liquid fund has invested in such a security, its NAV falls too. Recently, the net asset values of four of Taurus Asset Management Co. Ltd's debt schemes (one of which was a liquid fund) went down sharply because one of the companies in which all these schemes had invested in, defaulted on repayment. Typically, most debt funds invest in scrips that mature around 15 to 20 days to curtail their risk.

You can reasonably expect your liquid funds to return around 6-7% returns in a year.

What is so special about liquid funds?
Till date, when you take money out of liquid funds, you get the money in 1 day. Soon, liquid funds will give you money in a matter of minutes, with the help of technology. Some ultra short-term funds have been offering you this facility, but Sebi recently said that only liquid funds can offer this facility, and not ultra short-term funds. Sebi has capped this limit to Rs50,000 a day or 90% of your folio's value, whichever is lower.

In arrangement with HT Syndication | MINT

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