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How to select the best liquid funds to invest in India?

Liquid funds are the most heavily invested mutual funds around.

Why you may wonder!

The reason being liquid funds are more popular among corporations or companies than they are among retail investors.

It is easy to guess why if you know a that current bank accounts (used by businesses) have a zero-interest rate!

That’s right — when a retail investor parks his money in savings bank account, you earn an interest at a certain rate (4–6% as of now), but corporations earn nothing.

So, in essence, if a corporation parks its money in current bank accounts its money loses value due to inflation.

This means they have to find an option which is as good as bank or at least close enough. They are looking for a security which has –

There are two options that come to mind –

Overnight funds invest in securities having a maturity of one day; hence the name overnight. Liquid funds, on the other hand, invest in securities having maturities of up to 90 days.

Hence, corporations choose to invest in these securities instead of parking their money in current bank accounts.

Honestly, there is very little to choose between two liquid funds — pick up two good liquid funds and compare their returns, you’ll find a difference of a few basis points that will mostly not matter to you.

But no one invests in liquid funds to earn spectacular returns. The most important ask of any liquid fund investor is safety of capital. And hence, we will assess the universe of liquid funds accordingly to pick a few winners.

Surprised? Don’t be!

The surprise may come from the fact that experts advise to invest in mutual funds that doesn’t have a large AUM and avoid the large AUM mutual funds. And they are not wrong!

However, refraining from investing in mutual funds with large AUM is applicable by and large to equity mutual funds and even within equity mutual funds to mid and small cap funds the most.

Mid and small cap funds with large AUM will always find it more difficult to find good investment options than mutual funds with a smaller AUM. However, this tells nothing about future performance of the funds.

The mutual fund’s manager’s skills play a big role. But if two mutual fund managers with equal skill and experience are given two small cap funds to manage — one with an AUM of X and another with an AUM of 5X, the smaller fund is easier to manage and will most likely outperform the larger fund.

When it comes to liquid funds, however, large AUM is a very important and desirable criterion.

To help you understand why think about a fixed deposit that you invest in for 5 years; the interest rate you are going to earn is 7%. Assume there is an emergency and you are forced to pre-maturely withdraw from the fixed deposit before 5 years. Because you do so, there is a penalty levied which takes your interest rate down by 0.5–1%.

This is because the bank borrows money from depositors like us and lends it to borrowers in the form of loans. This has to be managed well else the bank could suffer from an asset-liability mismatch which may result in losses for the bank. Your fixed deposit is a part of an equation that the bank formulated when you invested in the fixed deposit.

When you withdraw prematurely, the bank may not lose a lot or at all, but if everyone acts like you and withdraws all at once, banks probably won’t be able to return your money immediately and may find itself in a very difficult situation. To avoid this undesirable scenario, banks generally levy premature withdrawal penalties.

Similarly, liquid funds invest in securities that have a fixed maturity (up to 90 days). If many investors redeem from the liquid fund, the fund manager will have to prematurely withdraw from securities and this will adversely impact returns for all investors!

While liquid funds generally have cash ready for scenarios like these, if the redemption pressure is beyond a certain point, the returns of the liquid fund will be adversely impacted.

For this reason, you should choose liquid funds that are large. These can handle redemption pressures better than liquid funds with smaller AUMs.

As a rule of thumb, you should invest in a liquid fund which has an AUM of at least Rs. 20,000 crores.

Only the following liquid funds have an AUM of Rs. 20,000 or greater –

Only these funds will be assessed further and other funds shall be ignored.

If you are looking at liquid funds, you are looking for safety and protection of your capital.

Your capital will be the safest if it is loaned out to the most creditworthy borrowers.

An absolute no-brainer!

We will check how much allocation do the above liquid funds have to highest quality securities.

Nippon India Liquid Fund has about 4% investments in unrated securities. This is quite large and alarming. Hence we will eliminate Nippon India Liquid Fund in this round. Other funds go through.

Expense ratio is among the least of our concerns for equity funds because the expense ratio differential between two comparable funds can be easily made inconsequential. (if fund A can deliver returns greater than fund B, fund B’s lower expense ratio doesn’t matter)

This is because active management in equity mutual funds is a very important aspect. This active management can drive the cost higher. But it also necessary to keep your portfolio optimized. A win-win situation!

One would be okay with paying 2% expense ratio for a fund that will generate 20% when compared with a fund with an expense ratio of 1.5% but a return of 18%. Returns between 2 equity funds can be drastically greater than 2–3% points — even if they belong to the same category.

However, when it comes to liquid funds, there is not a whole lot to do for the fund manager(s). For this reason, the expense ratios are substantially lower than those of equity funds. Generally, greater than 1.5% for equity funds and less than 0.3% for liquid funds.

In liquid funds, however, the returns are in a very narrow range — 7.2–7.6% (historically). Assume there are two funds that have expense ratios of 0.1% and 0.3%. By investing in a fund with an expense ratio of 0.1% you would have increased your returns by 0.2% by simply choosing to invest in it over the other!

But these are just a few basis points for retail investors and are unlikely to make a dent in your returns. This is because liquid fund investments are not generally made for the long term. Hence you don’t give the higher expense ratio time to compound and become visible.

This criterion, however, would be a big talking point for large investors where a few basis points translate to lakhs or crores of rupees! But again, it would be pointless to invest in a badly managed liquid fund just because the expense ratio is lower.

Here the total expense ratios of the funds that have passed the first two criteria –

We will publish the list of best liquid funds basis our analaysis very soon!

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