What is there to choose in a liquid fund? That could be the typical response if you were to tell someone how to choose a liquid fund. They are not entirely wrong. Most liquid funds invest in safe short-term paper and the returns on liquid funds are approximately the same. So what is there to choose between liquid funds? There are subtle differences between liquid funds which you need to be aware of. Let us look at different types of liquid funds and how to select best liquid fund. Here is how to choose liquid funds based on a 7-factor selection model.
Seven-factor selection for selection of liquid funds
1. Are the liquid funds really liquid?
This is an interesting question that you need to ask. When you compare the liquid funds check what is their time to redemption. Most liquid funds offer you T+1 redemption credit but in some cases, the redemption could go up to T+2 days. When you are using liquid funds as an instrument for parking your temporary surplus, access to funds at short notice is very important. There are some liquid funds that offer you an ATM withdrawal facility. Some liquid funs also offer you a week-end liquidity facility. Consider all these factors when you opt for a liquid fund.
2. Have the liquid funds outperformed bank deposits?
Let us begin with the purpose of liquid funds. They are an alternative to bank deposits. It is only when they can outperform bank deposits by 100-150 basis points that you can really enjoy the benefits of liquid funds. Of course, the tax efficiency of liquid funds compared to bank deposits is an added advantage. But the return advantage must be clear and unambiguous. If liquid funds are not able to give that 100-150 basis points margin over bank deposits then the very purpose is defeated.
3. How liquid funds react to sudden spurts in short term rates
This is not something you get to see on a daily basis. But consider July 2013 when the short term call rates spurted by nearly 200 basis points in a single day. If the liquid fund is holding on to longer term debt then the impact of this spurt in yields could be quite high. But if the holding is more of short term, then the impact may not substantial. The moral of the story is to focus on liquid funds that have shorter tenure debt in their portfolio so that the impact risks of spurts in call rates can be minimal.
4. Portfolio mix of the liquid fund and credit risk
This is partially a logical corollary to the previous point. Typically, the portfolio mix of the liquid funds will consist of CPs, CDs, call money and T-bills and a small portion of longer tenure debt. The idea is to focus on liquid funds that have portfolio tenure of around 91 days so that liquidity can be realized at short notice with minimal impact cost on the value of the portfolio. Also check for credit risk if there is too much of state debt or private debt in the portfolio of the liquid fund.
5. Is the liquid fund adequately diversified?
There are restrictions on debt funds exposure to a single group or business unit. However, the liquid fund can still have thematically large exposure to a particular sector or group. That is not a good idea and it is better that the portfolio is diversified. The portfolio of a liquid fund needs to be diversified across maturities, credit profiles and across sectors and themes. That will automatically manage the risk of these funds.
6. What about exit loads on liquid funds and near-liquid funds
One can argue that liquid funds do not charge exit loads but the definition of a liquid fund is quite wide and fluid. For example, a very short term liquid fund does not charge exit load but other classes of liquid funds like liquid-plus funds, ultra-short term funds do charge exit loads. The names of liquid funds can be quite deceptive for an investor and hence it would be better to clearly compare whether exit loads are being charged. Always opt for the zero-exit load liquid funds only, especially if you are using it for a systematic transfer plan (STP).
7. Deviation of the liquid fund returns from the mean
Why is the deviation of the liquid fund from the mean so important? For example, if the average return on liquid funds is 5.5% and a particular liquid fund is generating 7% then is that not good news? The answer is no! If you really want higher returns via higher risk then the investor can opt for a debt fund or a G-Sec fund where the returns can be higher with higher levels of risk. A liquid fund is supposed to earn slightly more than a bank deposit with negligible risk. A deviation in returns means a deviation in risk and watch out for this factor while comparing liquid funds.