Ever wondered where to park your extra cash that you might need in the next few weeks or months?

Many investors and businesses are struggling with this exact question. While traditional savings accounts have been the go-to option for decades, liquid funds are gaining popularity as an alternative.

But think about this question,

“Are liquid funds actually worth considering for your short-term money needs?”

In today’s KOFFi break, I’m going to explore liquid funds in detail, see how they compare with other short-term investment options, and help you decide if they make sense for your financial goals.

What Are Liquid Funds?

Liquid funds are a category of mutual funds that invest in extremely short-term money market instruments and debt securities with maturities typically up to 91 days. These include treasury bills, commercial papers, certificates of deposit, and other highly liquid money market instruments.

Unlike equity funds that invest in the stock market, liquid funds focus on the safety of your principal while providing better returns than a regular savings bank account. They’re designed for investors who need a place to park money temporarily while maintaining easy access to it.

How Do Liquid Funds Actually Work?

Liquid funds work differently from traditional investment options, and understanding their mechanics can help you make smarter decisions with your short-term cash. Let me break down how they really function:

Investment Strategy

Liquid funds invest in instruments that mature within 91 days, which is what gives them their “liquid” nature. A typical liquid fund portfolio might look something like this:

• Treasury Bills (30-40%): Government-issued securities that are virtually risk-free
• Commercial Papers (20-30%): Short-term corporate debt instruments
• Certificates of Deposit (15-25%): Fixed deposit instruments issued by banks
• Call Money/CBLO (10-20%): Ultra-short-term lending in the money markets

This diversified approach helps manage risk while maintaining liquidity and returns.

Liquid Fund Returns Structure

Liquid funds generate returns through two main channels:

1. Interest Income: The primary source of returns, coming from the interest paid by the underlying debt instruments
2. Price Appreciation: Though minimal in liquid funds, some gains can come from favorable price movements in the debt securities held

Currently, liquid funds are offering returns in the range of 6-7% annually, though this fluctuates with interest rate movements in the economy.

Expense Ratio Impact

One thing that sets liquid funds apart is their low expense ratio, typically ranging from 0.15% to 0.50%. This is much lower than equity funds, which means more of your money is actually working for you.

Let me show you what this means with a real example:

If you invest ₹10 lakhs in a liquid fund with a 7% gross return and 0.20% expense ratio:

• Annual gross return: ₹70,000
• Expense deduction: ₹2,000
• Net return: ₹68,000 (6.8%)

Compare this to a savings account offering 3.5%, which would give you only ₹35,000 on the same amount.

Tax Implications

Liquid funds offer tax advantages over traditional savings accounts, especially if held for more than three years. Here’s how they’re taxed:

• Short-term (up to 3 years): Gains are added to your income and taxed at your income tax slab rate
• Long-term (beyond 3 years): Gains are taxed at the investor’s income tax slab rate (Similar to Short-term Capital Gain).

For businesses, the tax efficiency often makes liquid funds more attractive than traditional fixed deposits.

Why Corporates Love Liquid Funds

Corporate treasurers across India have adopted liquid funds for their treasury management, and for good reasons:

Efficient Cash Flow Management

Companies with unpredictable cash requirements find liquid funds ideal. They can park surplus funds for just a few days or weeks and withdraw when needed, without worrying about premature withdrawal penalties.

Better Returns on Idle Cash

With corporate current accounts typically offering negligible interest, liquid funds provide a significant upgrade in returns on working capital. A company with ₹1 crore of operational cash could earn an additional ₹3-4 lakhs annually by shifting from a current account to a liquid fund.

Simplified Accounting and Taxation

Unlike fixed deposits where interest flows throughout the year creating accounting headaches, liquid funds growth is reflected in the NAV and recognized only when units are sold. This gives companies better control over when they book gains.

Are Liquid Funds a Good Alternative to Traditional Savings Accounts?

For many investors, liquid funds offer compelling advantages over traditional savings accounts. Here’s a practical comparison to help you decide:

This comparison shows why many investors are making the switch, especially those in higher tax brackets who need a short-term parking place for their money.

Liquid Fund Advantage [NAV Calculation and Instant Access]

One of the unique advantages of liquid funds is their NAV (Net Asset Value) calculation method. Most mutual funds calculate NAV at the end of the day, but liquid funds use a constant NAV method:

Constant NAV Calculation Method

Liquid funds calculate resulting interest on a daily basis and reflect it in the NAV. This means:

• You earn interest for every day your money stays invested
• Even weekend days count toward your returns
• There’s virtually no timing risk when entering or exiting

Instant Redemption Facility

Many liquid funds now offer instant redemption up to ₹50,000 or 90% of invested amount (whichever is lower). This gives you ATM-like access to your money 24/7, even on weekends and holidays, something a traditional savings account can match but most other mutual funds cannot.

How To Pick Better Liquid Funds

Not all liquid funds are created equal. Here are the key factors to consider when choosing one:

1. Fund Size and Longevity

Larger funds (₹5,000+ crores) with a track record of 5+ years typically offer more stability. They’ve weathered different market cycles and have established risk management systems.

2. Credit Quality of Portfolio

Always check the fund’s portfolio composition, the best liquid funds maintain at least 80-90% of their portfolio in AAA-rated or equivalent instruments. Funds with higher exposure to AA-rated papers might offer slightly higher returns but come with increased risk.

3. Fund House Reputation

Stick with established AMCs (Asset Management Companies) with strong risk management practices. Their conservative approach can be invaluable during credit events or market stress.

4. Expense Ratio

Lower expense ratio is better, even a 0.1% difference in expense ratio can significantly impact your returns over time, especially for large sums.

5. Exit Load Structure

Look for funds with no exit load for maximum flexibility.

Best Alternatives to Liquid Funds

While liquid funds are excellent, they aren’t the only short-term investment option. Here’s how they stack up against the alternatives:

Each option balances risk, return, and access to your money differently. The right choice comes down to your specific timeframe and liquidity needs.

Final Thoughts

Liquid funds strike an excellent balance between returns, safety, and accessibility for short-term investments. They work best as part of cash management strategy rather than as your only investment vehicle.

Before investing, take a good look at your cash flow patterns, how quickly you might need access to your money, and how comfortable you are with the minimal risk these funds carry. Compare expense ratios from different fund houses and read the fine print about instant redemption facilities.

Whether you’re an individual investor looking to optimize your emergency fund or a business seeking better returns on operational cash, liquid funds deserve a place in your financial toolkit.