How liquid mutual funds work: A beginner's guide to low-risk mutual fund investments

Liquid funds are a type of debt mutual fund designed primarily for short-term investments, focusing on securities such as treasury bills, commercial papers, and certificates of deposit. Their main goal is to provide a safe and flexible investment option, making them ideal for investors seeking low-risk avenues.

These funds have the lowest interest rate risk in the debt funds category, making them popular among investors and businesses for managing surplus cash or emergency funds. The article explores liquid mutual funds and what makes them low-risk mutual fund investments.

How do liquid mutual funds work?

The main objective of a liquid mutual fund is to grant capital protection and liquidity to investors. The fund managers pool capital from multiple investors and invest it in short-term, high-credit securities. The assets mature within 91 days, allowing fund managers to maintain liquidity and minimise interest rate risk. Investors can withdraw their capital quickly and without any restrictions. However, if they want to redeem their units within seven days of investment, a minimal exit fee is levied.

Why invest in liquid mutual funds?

Many investors consider liquid funds an ideal solution for short-term financial goals or emergency fund requirements as they offer several benefits. These include:

1. Lower risk:

Liquid funds are low-risk debt investments as they focus on safety and consistent returns. This approach helps maintain the value of liquid funds across various interest rate cycles. In contrast, debt mutual funds with longer maturity might experience significant capital gains or capital losses when interest rates fluctuate.

2. Flexibility:

An investor can park their capital in a liquid fund for short-term needs. There is a minor exit fee for redemptions within seven days but apart from this liquid funds have a flexible holding period. These funds allow investors to safely enter and exit while they get market returns for the period of investment.

3. Easy access and fast redemptions:

If an investor requests redemption of their funds, it is processed within one working day, facilitating rapid redemption. This is permitted because funds are invested in highly liquid securities that have a low default probability.

What to keep in mind when investing in debt funds

It’s important to note that while liquid funds are deemed as low risk, they are not risk-free. Liquid funds do carry minor risks due to fluctuations in interest rates and credit risks from the securities held in the portfolio. However, the overall short-term nature of liquid funds keeps the risks minimal.

Conclusion

Liquid funds are an ideal investment option for investors who have received a sizable payment or bonus and want to park their funds in a low-risk avenue. They serve as a safe haven, providing good returns, high liquidity, and low risk. This makes them an ideal starting point for investors exploring debt mutual fund investments.