Why fuss about liquid funds?

So much has been written about debt funds ever since the Franklin saga unfolded though liquid funds as a segment has largely remained unaffected and have infact been projected as fail-safe avenue. Are liquid funds really indispensable for retail investors portfolio? May be not.

Liquid funds as the name suggests tend to invest in short term debt instruments issued by government, financial institution or corporate having a maturity of 91 days. Thus, they are considered to be able to return money to investors should the need arise rather quickly, moreover the investments are in listed paper which could also be offloaded in case of severe redemption pressure. While this takes care of liquidity aspect, does it cover credit risk as well? Maybe not fully though one can argue that given the time period involved is just about 90 days, what can possibly go wrong in such short duration. Well, we have witnessed slippages in credit quality in less than 90 days in many cases. While there are regulatory guidelines in terms of sector and single borrower exposure with an intent to limit the credit risk in such schemes, but given the risk-return comparison across investment instruments my own experience suggests that for conservative investors, it can be completely avoided. Here are my own reasons for not investing in such instruments in my personal portfolio:

  • Contrary to the popular belief, liquid funds returns are comparable to large bank FDs (not the likes of medium and small private sector banks which come with their own share of concerns but handful of top banks which I consider safe-haven given systemic importance).
 Trailing Returns (%) Pre-taxYT June20201M3M6M1Y3Y5Y7Y10Y
CCIL T Bill Liquidity Weight1.80.31.12.04.14.24.44.74.8
Debt: Liquid2.20.31.22.45.36.46.87.47.8
SBI Deposit(4.0-4.5pro-rated)5.56.58.58.87.8
Source: Value Research, SBI

As liquid funds are typically held for less than 3 years as an interim avenue for a larger purpose, the tax advantages generally do not play out, banks deposits and liquid funds score similarly as both get taxed as regular income. If one is holding the liquid funds for a longer tenure say more than 3 years, then there is a need to revisit and re-balance the investments as there are better options available possibly in the fixed income space itself.

  • Liquid funds too have varying degrees of risk based on underlying instruments subscribed by the fund manager irrespective of scheme mandate which generally describes the rating (AAA, AA as both could be A1+ on short term scale) or issuer (sovereign or others). Thus, all liquid funds are not be the same and require an understanding of degree of risk by going through the fund composition or better sticking with large bank deposits which offer better risk-return trade-off.

In short, the good old deposits can be equally attractive if scattered across maturity (some part in saving deposit typically the emergency corpus which is instantly available and then in term deposits of varying maturities) which can match the return on liquid funds albeit at a lower risk. While better informed investors can benefit marginally from liquid funds by right selection and timing the investments, but not a must-have and can be ignored in general as the money typically parked in liquid funds is either emergency corpus or goal-based saving waiting for right opportunity, thus need to ask oneself if its worth the credit risk to chase tad better return in liquid fund if any.

As an individual, I am all in for fixed income in a portfolio and there are alternatives which need to be weighed across risk, return and ease of liquidity. Just that hype around liquid funds does not excite me!

  • One argument which takes the cake is that liquid funds are absolutely easy to liquidate without any premature penalty that deposits are subject to. Premature withdrawal penalty is a cost which can definitely dampen the returns, but cost can manifest itself in other forms too like the variability in expense ratio or marked to market impact in case of liquid funds or the latest one which levies stamp duty on mutual fund transactions. This aspect to me is not as big a pro for liquid funds as is made out to be given deposits can be staggered so as to minimise pre-mature drawl and penalties. Further, long tenor deposits can be leveraged to take loans at zero processing and pre-payment penalty, but liquid funds have to be liquidated only at the marked to market price.

Thus, if you are feeling restless about having missed the bus on liquid funds and looking to switch from deposits just because of herd behaviour, don’t fuss. There are far more critical aspects of your savings that need attention.

Disclosure – These are personal views based on my experience of evaluating various instruments for own good. This is not a recommendation and I am not a SEBI-registered advisor, just a DIY investor.

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