A liquid fund is a debt fund at the shortest end of the time spectrum. A liquid fund typically invests in debt instruments with a residual maturity of less than 90 days. That means; the money is allocated to call money lending, commercial paper, certificates of deposits, treasury bills, government bonds with residual maturity less than 90 days etc. Liquid funds are taxed like debt funds but the returns can be slightly higher than what you can earn on a savings bank account. Being invested in very liquid assets, you can monetize these liquid funds on the same day. In addition, these liquid funds can be structured as a systematic withdrawal plan such that it is a lot more tax efficient since you are only taxed on the capital gains made but your withdrawal also includes the principal component which is not taxed. But that is not the only reason to use liquid funds. The other big purpose is to convert the lump sums funds into an SIP investment. This is done via liquid funds by using a technique called the systematic transfer plan (STP).
How do STPs and liquid funds work together?
We all know the merits of systematic investment plans (SIP). Since you invest small bits each month, you not only get into the discipline of savings but also are able to sync your outflows with your income. In addition, by using the SIP route, you get the benefit of rupee cost averaging (RCA). Since you are allocating a fixed sum each month, you get more value when the markets are up and more units when the markets are down. Effectively, over a longer period of time, you have a fund where the average cost is lower and therefore the ROI is higher. But how do you apply this principle when you earn a lump sum as a bonus. You still want to invest smartly with the benefit of rupee cost averaging. You can opt for STP.
Here is how the STP works. You invest the entire corpus in a liquid fund and then sweep a fixed sum out of the liquid funds into an equity funds. You virtually hit two birds with one stone. On the one hand, your idle money earns nearly 2% more than a bank savings account in a liquid fund and the withdrawal is smooth due to no exit loads and due to tax efficiency. This money is invested as a SIP into an equity fund so the benefit of long term wealth creation and rupee cost averaging is available to you.
Using a combination of lump sum and STP in practice
A lump-sum can also give you the benefit of SIP. Here is how it works. Say, you just received a bonus of Rs.5 lakhs and you want to invest the money in an equity funds. But you are not sure of the bottom of the market and you expect the market to be volatile in the coming months. How about spreading your lump sum of Rs.5 lakhs and converting that into an STP of Rs.25,000 for the next 20 months. Let us also assume that the equity funds will generate a return of 15% while the liquid fund pays you 6%. For simplicity we ignore taxes. Here is how the STP will look like.
Balance in UST Fund
Return at 0.5% p.m. on UST
Equity Fund SIP Corpus
Equity Fund Returns 1.25% pm
Value at the end of 20 months = X + Y + Z
Had you done a pure SIP, your corpus would have been worth Rs.5.71 lakh at the end of 20 months. Instead, the STP gives you the benefit of an SIP as well as the idle corpus is better used in a liquid fund instead of savings bank account. The STP has enabled you to grow your corpus of Rs.5 lakh into Rs.5.89 lakh at the end of 20 months. That is the added advantage that STP offers to you.
The big challenge when you get lump sum payments is to time the market. Nobody has done it precisely; and nobody perhaps will be able to do. The next time you get a lump-sum, don’t fret about it. You can convert this lump-sum into an SIP by using the STP route. Effectively, you hit two birds with one stone!