What are Liquid Mutual Funds & How They Work

Liquid Mutual Fund

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Liquid mutual funds can be a better alternative of your regular bank saving account and it can be a good alternative of your traditional and favorite investment option, which is Fixed Deposits (FDs). These funds are a type of mutual fund that invests primarily in short-term, high-quality money market instruments such as Treasury bills, commercial paper, and certificates of deposit. They are designed to provide investors with a high degree of liquidity, meaning you can quickly and easily access your money with minimal risk of loss.


How Liquid Mutual Funds Generate Returns

 Liquid mutual funds generate returns through interest income and capital appreciation. Here's a simple breakdown of how they work:

  1. Interest Income: The primary source of return for liquid mutual funds comes from the interest earned on the short-term securities they invest in. These are typically low-risk instruments that pay interest over a short duration.
  2. Capital Appreciation: While the focus is on generating steady interest income, there can be minor capital gains if the prices of the securities in the portfolio increase. However, this is not a significant source of return for liquid funds.

Methodology and Principles

Liquid mutual funds operate based on several key principles and methodologies:

  1. Short-Term Investments: These funds invest in instruments that mature within 91 days. This short duration minimizes the risk of interest rate fluctuations affecting the value of the investments.
  2. High-Quality Instruments: Liquid funds typically invest in high-credit-quality instruments, reducing the risk of default. These include government securities and high-rated corporate papers.
  3. Diversification: By spreading investments across various short-term instruments, liquid funds aim to reduce risk and ensure a steady return.
  4. Professional Management: These funds are managed by professional fund managers who carefully select the instruments to invest in, aiming to optimize returns while maintaining liquidity and safety.

Vision and Objectives

The primary vision and objectives of liquid mutual funds include:

  1. Capital Preservation: Protecting the principal amount invested while generating modest returns.
  2. Liquidity: Providing high liquidity, enabling investors to quickly access their money when needed. Some Liquid Funds provide 24/7 redemption facilities.
  3. Low Risk: Minimizing risk by investing in short-term, high-quality instruments.
  4. Regular Income: Offering a steady income stream through interest earned on investments.

Risks Associated with Liquid Mutual Funds

While liquid mutual funds are considered low-risk, they are not entirely risk-free. Here are some potential risks:

  1. Credit Risk: The risk that issuers of the securities in the fund's portfolio may default on their payments. This risk is minimized by investing in high-quality instruments, but it cannot be entirely eliminated.
  2. Interest Rate Risk: Although liquid funds invest in short-term instruments, there is still some exposure to changes in interest rates. If interest rates rise, the value of existing securities with lower rates may fall, affecting the fund's returns.
  3. Liquidity Risk: In extreme market conditions, the liquidity of the instruments in the fund's portfolio might be lower than expected, making it harder to sell them quickly without impacting their price.
  4. Market Risk: Although minimal, market fluctuations can still affect the returns of liquid mutual funds.

Final Thoughts

Liquid mutual funds offer a convenient way for investors to park their surplus funds for short durations with the benefit of high liquidity and relatively low risk. They are ideal for managing short-term cash needs, such as an emergency fund or saving for an upcoming expense. Understanding the methodology, principles, vision, and associated risks can help investors make informed decisions and use liquid mutual funds effectively in their financial planning. liquid funds can be an alternative for ones saving account or a short term fixed deposit. We have done a comparison between Liquid Funds and Fixed Deposit that you can also read.

#Check out --> TOP LIQUID MUTUAL FUNDS


#DISCLAIMER: Mutual Fund Investments are Subject to Market Risk. Read All Scheme Related Documents Carefully before investing.