February 01 , 2013
What is a liquid fund?
A liquid fund (also called cash fund or money market fund) is an alternative to your savings bank. It is a mutual fund that can be used as a temporary place to park money. It usually offers slightly higher returns than the 4% of a savings bank; while having the same safety and flexibility.
A liquid fund does this by investing your money in very short term paper. Such paper is issued by banks or by the Government when they want to borrow money for the short term. The tenure or duration of such borrowings can be as less as overnight, to as long as a year. A liquid fund invests only in such paper.
Advantages of a liquid fund
Since the liquid fund invests in paper of very short maturity and duration, it does not get affected by changes in interest rate. Also, the risk of default in any of these papers is negligibly small.
Thus, the liquid fund may be used an alternative to keeping money in savings account. While the latter gives a fixed 4%, an average liquid fund may give (depending on market conditions) 8.5%-9% annually. Further, you can withdraw the money at a day's notice, without any penalty.
Limitations of a liquid fund
A liquid fund is meant to be a temporary place to park money. Over the medium to long term, its returns will be low - rarely more than inflation. You would do well not to use liquid funds for regular savings and investment purposes.
Is a liquid fund for me?
In general, a liquid fund is used by corporates and high net-worth individuals who have large sums of money parked in their bank accounts. For others, the difference in interest between a liquid fund and a savings account is too small to go through all the trouble.
That said, if you find yourself having too much balance in your savings account (say more than three months of expenses), you can consider moving most of it to a liquid fund. After all, a liquid fund is as flexible and safe as a savings account - and gives you slightly higher return.
How do I choose my liquid fund?
Almost any liquid fund is good as another. Unless you are a stickler for one-tenth of a percentage point of return, you need not spend too much time in choosing a fund. Just opt for one of the better known fund houses (ICICI Prudential, HDFC, Birla, Franklin or Reliance) and go with their liquid fund. If you still want to do more research, you can look at their performance in the last one year, and choose the best one.
There is no need to, or benefit in diversifying with 2-3 liquid funds. Since these are only meant to be a temporary parking place for money anyway, you can stick to one.