Liquid funds: A deep dive into short-term investment safety

When it comes to securing your financial future, exploring various investment avenues is essential. Among the many options available, liquid mutual funds stand out as a safe and accessible choice for short-term investment.

Let’s deep dive into this category, knowing if it is safe and how it can benefit you.

What are liquid mutual funds?

Liquid mutual funds represent a category within debt mutual fund investments, primarily focusing on short-term investments in highly liquid money market instruments. These instruments, including commercial papers, certificates of deposit, treasury bills, and term deposits with scheduled commercial banks, boast short maturity periods, typically up to 91 days. Such characteristics render them low-risk and highly liquid options for investors seeking stability in their portfolios.

How do they work?

Pooling funds from various investors, liquid funds channel resources into a diverse array of short-term money market instruments. The returns yielded by these investments, net of expenses, are subsequently distributed among investors in the form of dividends or capital gains. Operating as open-ended funds, investors retain the flexibility to enter or exit their positions at any time, with the net asset value (NAV) recalculated daily to reflect the fund's performance.

Are liquid mutual funds safe?

While considered relatively safe due to their investment focus on high-rated entities, it's crucial to remember that no investment is entirely without risk. Liquid fund investments are exposed to:

• Interest rate risk: Fluctuations in interest rates can impact the fund's returns.
• Credit risk: The possibility of the issuer defaulting on their obligations can lead to losses.
• Market risk: Overall market fluctuations can affect the fund's NAV.

Things to remember before investing in liquid funds

Returns on funds: Before committing to a liquid fund, a thorough analysis of its historical returns is imperative. Although these funds lack a lock-in period, the short-term nature of their investments demands scrutiny of returns over an extended period to gauge the fund's performance trajectory effectively.

Portfolio diversification: Opting for funds with robust diversification can mitigate risks associated with market downturns or unforeseen events. A well-diversified portfolio can offer resilience in the face of adverse market conditions, providing investors with a buffer against potential losses.

Expenses and charges: Given the similarity in returns among liquid funds, minimising expenses becomes pivotal in selecting an optimal investment avenue. Identifying funds with lower annual charges, initial expenses, and ancillary fees can enhance the overall returns on investment, maximising the benefits for investors.

Bottom line

Liquid mutual funds provide a valuable tool for managing short-term finances in India. By understanding their characteristics, potential risks, and key considerations, you can make informed investment decisions and leverage their safety, liquidity, and modest return potential to achieve your financial goals.

Compare different liquid funds based on their returns, expense ratios, and other key parameters. Also, use an online SIP calculator to estimate your potential returns from regular investments in liquid funds.