If you are evaluating the options to invest in mutual funds, chances are you have learned about liquid funds. In India, investors can select to invest in a liquid fund for short-term purposes. These funds have got the name from their primary feature, liquidity. Let's first understand the characteristics of a liquid fund, and then we will discuss how one can select the best liquidity funds in the market.

What Is A Liquid Fund?

Liquid funds are a type of debt fund to generate short-term, risk-free returns. Most liquid funds invest in debt instruments, like treasury bills, commercial papers, and similar asset classes with a maturity period of 91 days. It offers a high degree of liquidity to investors while protecting base capital. Short maturity reduces market sensitivity from the changes in the interest rate, which helps to deliver higher returns.

Liquid funds are an excellent option to invest excess funds while enjoying a higher return from a regular savings bank account. These are low-risk havens that emulate the liquidity feature of savings bank accounts.

So there are two critical features of liquidity funds that make it one of the most heavily invested options.

High liquidity

If you try to redeem liquid funds, you usually get the proceeds in one or two days. Liquid funds offer liquidity like the savings accounts of a bank.

High safety

Liquid funds invest in debt instruments that ensure protection to your capital while earning a risk-free return.

Corporations and businesses invest heavily in liquid funds since it ensures both liquidity and capital protection, whereas a current account with a bank attracts zero interest. If they put their funds in a current account, it will lose value due to inflation.

How To Select The Best Liquid Fund

Liquid funds serve the primary purpose of offering a temporary investment option to perk your excess funds if you are not sure where to invest. The primary goal is to ensure liquidity and safety of capital, and since no one considers liquid funds for long-term investment, there is very little to choose from. One can compare returns between two funds and select one. Let's look at the criteria that will help you pick a good liquid fund.

Significant AUM

We know that AUM is critical to select a good mutual fund. Experts always suggest looking at the AUM size before investing mainly because a significant AUM is a metric that indicates a fund's cash flow.

When it comes to liquid funds, significant AUM is an important criterion.

When you withdraw from the bank's savings account, it doesn't impact the bank's income. But if there is a high pressure to withdraw from a liquid fund, it may affect its performance. A significant AUM provides the cushion while allowing high liquidity. As a rule of thumb, a liquid fund with an AUM size of Rs 20,000 crores is a good enough investment option.

Credit Rating

For liquid funds, a high credit rating is essential. It confirms the safety and protection of your capital. A triple-A rating indicates that the fund lends out to high creditworthy borrowers and guarantees timely returns. Hence, you must confirm how much fund it allocates to unlisted or to-be-listed equities or debt securities while selecting a liquid fund. SEBI has recently modified the threshold from 25 percent to 5 percent, which is a drastic change.

Also, be mindful that ratings keep changing based on the fund's performance; hence, always check the ratings before investing.

Low Expense Ratio

The expense ratio reflects the cost of managing the fund. Since active management is critical for mutual funds' performance, it results in a higher expense ratio, but it is also necessary to keep the fund optimised. With liquid mutual funds, managers have little to do, and hence, the average expense ratio of these funds is lower than equity funds.

Historically, liquid funds produce a return of 7.2-7.6 percent, and a fund with lower expenses ratio will put more money into the investor's pocket.

Top-performing Liquid Funds In India

Following is a list of the top-performing liquid funds in India with AUM more than Rs 20,000 crores. We suggest you research the market and select funds with the highest rating that meets all the above criteria.

Fund NameAUM in Rs crore as of January 2020
HDFC Liquid Fund - Growth72,123.14
ICICI Prudential Liquid Funds - Growth55,664.87
Aditya Birla Sun LIfe Liquid Fund40,854.28
SBI Liquid Fund46,759.17
UTI Liquidity Cash Fund30,477.37
Kotak Liquid - Regular Plan - Growth27,114.39
Nippon India LIquid Fund - Growth24,235.58
Axis Liquid Fund - Growth29,118.52

Conclusion

Investors often choose liquid funds over regular savings accounts to perk a windfall of funds temporarily. This way, they ensure the liquidity and safety of their capital while enjoying a decent return from investment. However, liquidity funds are not for long-term purposes, and hence, you can plan a systematic transfer of funds from a liquid fund to a mutual fund to enjoy earning returns from both.