When should you invest in liquid mutual funds?
Liquid funds are often marketed as savings account or fixed deposit replacements.
While the finance industry is known to have created a lot of redundant products, liquid fund is quite useful.
As the name suggests, the fund is invested in for the high liquidity it provides. Liquidity refers to the conversion of an asset to cash – a high liquidity indicates easy conversion.
Liquid fund is a fund that people invest in so that if they ever need cash they can always turn to liquid fund and redeem money with no terrible consequences.
While most mutual funds let you redeem money freely, there are consequences – one of the most dangerous is sub-par return or capital erosion! This is almost non-existent when it comes to liquid funds. The returns are stable and capital erosion is rare – though possible!
Liquid funds have traditionally yielded very stable returns – it is easily the least volatile mutual fund category out there.
But liquid funds cannot replace fixed deposits – especially long-term fixed deposits.
Fixed deposits have a fixed interest rate (you know what you are going to get) – liquid funds don’t!
Fixed deposits have different rates for different periods – liquid funds expected returns are same for a period of 1 months, 1 year, 10 years!
Fixed deposits are not highly liquid – you are charged a 1% interest rate penalty for premature withdrawal – liquid funds have no such exit restrictions.
Long term fixed deposits (3 years and greater) are less tax-efficient than liquid funds if held for 3+ years. This is due to the benefit of indexation that substantially reduces the long term capital gains tax on liquid and other debt mutual fund categories.