Disadvantages Of Liquid Funds: After gaining even a slight bit of financial knowledge, you would surely agree that savings, in the long term, is not a solution to retiring with a certain amount of wealth. While keeping some cash in hand is necessary, it is not necessarily going to create wealth in the long run.
If you want to generate moderate returns, without having a long-term lock-in period for your money, liquid funds seem like a suitable option. In this article, we’re going to write about liquid funds, their features, and the disadvantages of liquid funds.
What Are Liquid Funds?
Liquid funds are basically debt-based mutual funds that primarily invest in fixed-income securities like government bonds and treasury bills. Such liquid funds have a maturity of up to just 91 days or three months.
Liquid funds are supposedly much more secure, stable, and risk-free than long-term bonds because of their short-term maturity, and SEBI guideline that only allows them to invest in debt instruments.
While liquid funds are technically mutual funds, they have some unique features that make them different from other debt-based funds. Let’s take a look at some of the major features of liquid funds.
Features Of Liquid Funds
- A liquid mutual fund will only hold debt-based securities that are of short duration, have a positive credit rating, and are very liquid i.e., they can be easily converted into cash. SEBI has made these conditions mandatory in order for a fund to classify itself as a liquid fund.
- The purpose of liquid funds is to ensure that these funds are highly liquid in nature, and that means investing in low-risk, stable securities such as listed commercial papers and government bonds. They are supposed to have a maximum of 20 percent exposure in a sector.
- Also, 20 percent of the fund must hold liquid products such as cash and cash equivalents. This is to ensure that in case of redemptions, the fund can be redeemed as soon as possible by investors.
- Given that liquid funds have a very short maturity period combined with the fact that they are mainly debt and cash investments, there are very few capital gains that can be expected. Such funds mainly earn through interest on their debt holdings.
Only long-term debt instruments face volatility because of the changing interest rates, which inversely affect the prices of bonds in the market. An increase in interest rates means a fall in bond prices and vice versa.
- Liquid funds are affordable as they aren’t actively managed like other mutual funds. This is why liquid funds have a fairly low expense ratio, which is a good sign for investors. This also reduces the exit load fees that are associated with most mutual funds.
- Quick Redemption process: Liquid funds have a much faster redemption process than other funds. The redemption process happens within one day, meaning a liquid fund sold on Monday would see the investor receiving their cash by Tuesday. Unlike most funds, there is also no lock-in period.
Disadvantages Of Liquid Funds
Now that we’ve covered the main features of liquid funds, let’s take a look at the disadvantages of liquid funds. Every investment comes with its unique set of pros and cons. The same applies to liquid funds as well. So what are the major disadvantages of liquid funds? Read below to find out!
- While liquid funds have a relatively low risk compared to stocks and even other debt funds, this doesn’t mean there is no risk at all. In fact, there isn’t any guarantee that your principal is secure either. Compare it to a fixed deposit.
If you held a fixed deposit of ₹2 lakhs for 3 years, irrespective of what returns were promised to you at the start of the deposit, your ₹2 lakh investment will be returned to you after maturity. The same cannot be said for liquid funds.
While liquid funds only invest in AAA-rated bonds and securities, which are one of the safest debt securities in the market, it doesn’t necessarily translate to an assurance of principal safety.
- Liquid funds mature quicker than most funds, and the gains from such investments fall under the short-term capital gains tax. STCG tax rate in India is 15 percent, which is more than the LTCG tax rate.
Liquid funds are a great opportunity to park idle/excess cash as it gives some form of return, even if it is on the low end of market performance. Additionally, it has no lock-in period, so investors can sell their units quickly too. Like every investment, it has its drawbacks.
One of the disadvantages of liquid funds is that they cannot promise the safety of principal investments like fixed deposits. We hope you have a better understanding of liquid funds from this article. Happy Investing!
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