Why are liquid funds gaining favour with retail investors?

Liquid funds, a type of debt mutual fund, are gaining traction among retail investors for several compelling reasons. Offering easy access to cash and predictable returns, these funds primarily invest in short-term debt instruments like treasury bills and commercial papers, ensuring stability and liquidity. In March alone, liquid mutual funds saw an outflow exceeding Rs 1.5 trillion, highlighting their significance in the investment landscape. Let’s explore the underlying factors fueling the growing preference for these financial instruments.

1. Stability in short-term investments:

Liquid funds specialise in short-term investments with up to 91 days of maturity. These funds achieve stability and minimise market risk by investing in highly liquid money market instruments, which are discounted papers that give a face value of Rs 100 at maturity. These comprise commercial papers from reputable companies, certificates of deposits from banks, government treasury bills, and dated securities with residual maturities not exceeding 91 days. 

2. Enhanced returns compared to savings accounts:

All the papers in the portfolio of liquid funds have a yield to maturity, which means they generate a certain amount of returns when held until maturity. The weighted average of these returns across all the papers in the portfolio is known as the Yield to Maturity (YTM). It represents the overall expected return of the liquid fund’s portfolio. With yields typically higher than traditional savings accounts by 150 to 300 basis points, liquid funds allow investors to earn reasonable returns on their surplus cash without sacrificing liquidity. This makes them an attractive alternative for short-term investments.

3. Regulatory safeguards:

The main risks in liquid funds are:

Liquidity risk: This is about how easily the fund can convert its investments into cash if needed.

Credit risk: This relates to the risk of the companies or entities issuing the instruments being unable to pay back the money they owe.

Mark-to-market risk: This refers to the potential changes in the value of the investments due to market fluctuations.

Securities and Exchange Board of India (Sebi) has set rules to manage these risks. For example, they require a minimum of 20% of the portfolio to be kept in cash or government securities to ensure there’s enough money available for investors to redeem their investments. If this falls below 20%, the fund can’t buy more commercial papers or certificates of deposit until the ratio is restored. 

Another rule is conditional redemption at risk (CRAR), which involves how the fund handles redemptions during stressful times. To ensure there’s enough cash available, the fund needs to hold assets like cash, government securities, and highly-rated commercial papers or certificates of deposit. 

This helps ensure the fund can meet redemption requests without any issues. 

4. Low to moderate risk profile:

On average, the liquid fund’s portfolio matures within 30 to 45 days, indicating that the investments are short-term. The papers in the liquid fund are very easy to convert into cash. They also have low mark-to-market risk, meaning that changes in their market value don’t significantly affect the overall portfolio. Due to their short maturity period and high-quality portfolio composition, liquid funds are classified as low to moderate-risk investments. This classification, coupled with Sebi’s risk-o-meter rating system, provides investors with transparency and confidence in the risk profile of these funds.

5. Accessibility and flexibility:

Investors can easily buy and sell liquid funds whenever they want without worrying too much about the impact on their returns, which are usually close to the portfolio’s expected returns. These funds allow investors to enter and exit the fund at short notice, making them suitable for managing short-term cash requirements. Moreover, the ease of transactions and relatively stable returns make liquid funds attractive for investors seeking convenience and liquidity.

(The author is  Head – Fixed Income, Tata Asset Management)