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Why liquid funds can be good for you

Suresh Sadagopan in Mumbai | October 07, 2008 08:59 IST

There are two categories of funds that have caught the imagination of investors these days -- liquid and liquid-plus funds. Though, at present, most of the money in these funds comes from institutional investors, the retail investor is slowly beginning to realise their benefits. These funds can prove to be useful for the retail investor to manage their short-term surpluses.

In the last one year, liquid funds have returned between 7.7 per cent and 8.85 per cent. Liquid-plus funds, on the other hand, have slightly higher returns between 8.4 and 11.29 per cent. Obviously, that makes them a better choice as against money earning a dismal 3-3.5 per cent in your savings account. Let us look at these two options in detail.

Liquid funds: These funds invest in short-term debt instruments with maturities of less than one year. A liquid fund would normally provide good liquidity, low interest rate risk and the prevailing yield in the market. Therefore, they invest in money market instruments, short-term corporate deposits and treasury. The maturity of instruments held is between three and six months. Liquid funds have the restriction that they can only have 10 per cent or less mark-to-market component, indicating a lower interest rate risk.

As far as costs go, they have an exit load, if the investor redeems before the lock-in period. But these periods are rather low -- in most cases, around 7-10 days. The only disadvantage liquid funds has is that investors cannot take the advantage of higher returns being offered by long-term instruments. But the biggest benefit is that though the returns are lower, the risk is nominal, making it an ideal instrument for parking short-term funds.

Liquid-plus funds: These funds were launched to cater to those with a stomach for slightly higher risk, and as a result higher returns. A typical liquid-plus fund will have similar investments like a liquid fund, but around 30 per cent of the corpus is invested in instruments with longer maturity period.

They do not have any restriction on the mark-to-market component (liquid funds can have only up to 10 per cent) and there is no lock-in period for the liquid-plus funds category. Also, liquid-plus funds are a hit as they are more tax-efficient. The dividend distribution tax works out to 14.16 per cent as against 28.33 per cent for liquid funds.

As it can been seen, the positioning of these two categories is quite different. That is, they provide an option between short-term liquid funds and other long-term debt funds. They are, hence, attractive for those who want a slightly higher return without going all the way with only higher tenure investment options.

Though the performance of these two funds is similar, in a rising interest rate regime, long-term maturity papers are observed to be riskier and their value reduces. This leads to loss of returns of liquid-plus funds.

In the recent times, tough market conditions and the fear in investors have hit the assets under management of both these funds. Especially, corporate investors have been cautious. This has led to a negative impact of the expense ratio on the returns.

As the tax treatment of liquid-plus funds is better, they would still outperform, considering the net-of-tax parameter. This is why retail investors can consider this as a more sensible option, albeit at higher risk, to invest their money in the short term.

The writer is a certified financial planner.

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