Liquid Funds have been around for a long time. The first Liquid Fund, as per Value Research, was launched in 1997. Today, almost all mutual funds have a Liquid Fund.
Liquid Funds have also come a long way in terms of the market risks that it can take. I have heard of instances of longer tenor bonds being part of Liquid Fund portfolio in the early 2000 till SEBI in its steadfast investor protection introduced maturity restrictions in Liquid Fund portfolios.
Post the 2008 global financial crisis and with the RBI having to offer a Liquidity Window for Mutual Funds to meet redemption, SEBI tightened the norms further by eventually mandating that Liquid Funds can only invest in instruments which are 91 days or less in maturity. This took away any ambiguity on the extent of market risks that investors would bear in a liquid fund.
Liquid Funds now almost came at par with short term fixed deposits in terms of its return profile. This greatly benefited marketing and positioning of Liquid Funds over bank deposits.
SEBI recently also introduced standardized fund categories by using maturity bands to demarcate Debt Fund categories. Liquid Funds, in the new definition, are funds which have investment in Debt and Money Market Securities with maturity of up to 91 days only. This continues the earlier practice of ensuring that Liquid Funds carry low interest rates risks, but this still does not account for the credit risks (risk of default of interest and principal) that a Liquid Fund can take.
The investment objective of a Liquid Fund is to keep our investment safe and liquid and try and achieve better returns than bank deposits. This is how a Liquid Fund is positioned and marketed to investors. Liquid Funds offer T+1 liquidity, as also instantaneous redemption upto Rs. 50,000.
Thus, Liquid Fund portfolios should have very high liquidity, minimum volatility and near zero chance of capital loss. Liquid Funds should thus prioritize safety and liquidity over returns. But most Liquid Funds of today are prioritizing returns over safety and liquidity. The recent cases of defaults reported in Liquid Funds are a fall out of this aspect of chasing returns over safety.
As per data from AceMF, today, an average Liquid Fund holds around 60% of its assets in instruments issued by Private Sector. A good share of that is invested in private corporate which are not AAA rated. About a third of the assets are invested in instruments issued by NBFCs (Non Banking Financial Corporations). The Liquidity and the Credit quality of these instruments may not be commensurate to the liquidity and safety objectives of a Liquid Fund, thus compromising on the very objective of liquid fund.
Retail Investors invest their short term cash surplus in Liquid Funds to earn more than bank deposits. Financial Planners advise Equity investors to park their lump sum money into Liquid Funds so as to be able to switch/transfer their allocations to the equity fund at regular intervals. Equity Mutual Funds, PMS Managers park their cash holdings in Liquid Funds waiting for an opportune time to buy Equities. Most of them may not be aware and/or not prepared to see a capital loss in their liquid fund investments.
So, before investments in the liquid fund, it is very essential to scrutinise the investment portfolio of that liquid fund scheme and see how much credit risk forms part of the portfolio. We prefer Liquid Funds which do not take credit risks. For safety and liquidity, look for those liquid funds which invest only in Government Securities, Treasury Bills and AAA rated instruments issued by Public Sector Undertakings (PSUs).
Source : Quantum Mutual Fund