If you have some spare funds lying idle in your bank account for a short duration, perhaps the better way to make more money out of your idle funds is to invest into Liquid funds. Our article How to make money from IDLE funds in your Bank account details more about this way of investing your funds. However, I thought that I should write another article to discuss on the safety of Liquid funds while are a primary instrument in investing funds over a short duration. Liquid funds are also called as Money Market Mutual Funds as they primarily invest in money market instruments, i.e. investments having a maturity of less than 90 days.
The two key features of liquid funds which make them stand out from rest of the funds are :
1. They invest in high quality debt instrument (zero equity)
2. Their returns do not fluctuate violently unlike Equity or other Debt funds
Regulatory Safety Requirements
In order to add to the safety net of Liquid Funds, the Indian regulator – SEBI has specified regulations which restrict the mutual fund houses to invest the funds of a liquid scheme only in specific products along with overall limits beyond which a fund house can not invest in different sectors and types of investments. A few of such restrictions are
1. Not more than 10% into unrated debt – which means that the fund manager can not invest the funds in poor quality assets beyond 10% of the fund’s size. As a corollary it also means that most of the investments would be rated and hence it would be transparent to an investor ;
2. Not more than 30% of its funds in money market instruments of a single issuer – which means that the fund houses will have to diversify its investments across different issuers. Too much investment in securities issued by one issuer makes the scheme vulnerable to such issuer;
3. Not more than 30% of its funds in one sector – this requires fund manager to diversify the funds in debt securities of different sectors to prevent any specific sector downtrend to negatively affect the fund. Generally the higher risk a sector has, the more interest rate it will give on its deposits. Putting an overall cap on the sector exposure prevents a fund manager to take extreme amount of exposure in such sectors in order to enhance the returns of the fund.
4. To prevent syphoning of the funds to the sponsors of the mutual fund houses, SEBI has barred fund managers from :
(a) investing in any unlisted security of an associate or group company of the sponsor; or
(b) any security issued by way of private placement by an associate or group company of the sponsor; or
(c) Invest in excess of 25% of its funds in the listed securities of group companies of the sponsor. Listed securities are publically available for investing and even then SEBI has put an overall cap on such investments as well.
The above points will prevent for example HDFC Mutual fund to invest in any unlisted securities of HDFC group or via any private placements. Such investment options are not transparent and potentially may not be investor friendly.
5. A very specific requirement for money market / liquid funds is that the fund manager can not invest in debt securities of maturity greater than 91 days. This has a massive impact in helping to reduce the volatility of a liquid fund. If you would read our article Debt Funds – Get Exposure to Bonds, you would realise that the price of a bond instrument is inversely proportionate to the interest rate movements in an economy. However this is true for debt securities whose maturity is mid to long term duration. As bonds approach closer to the date of its maturity, the investors know that shortly they would be paid the maturity price of the bond. Hence any investor in such bonds will not be ready to pay more than the maturity value of the bond – this results in very low or minimal fluctuations in the returns and prices of the bonds. A money market scheme by investing in short duration debt instruments hence shields the scheme from price fluctuations or in other words provides more stable debt returns.
Example of a Sample Liquid Fund – HDFC Cash Management Fund – Saving Plan
Let me reflect a few of the points mentioned above in the form of a real example from HDFC Cash Management – Saving Plan’s portfolio and see how it complies with the SEBI requirements (Data as of June 2013) :
1. Average maturity – The fund’s investments have an average maturity at 41 days. This is much lower than the required 91 days.
2. The fund is invested 100% money market instruments with a small exposure into Bonds. There is no exposure in volatile assets class like Equity shares.
3. Approx 95% of its investment is in high credit quality debt (AAA rated). Remaining is in AA rated debt. (source Morningstar.co.in)
From tax perspective, Liquid fund attract capital gain tax. If you sell them before 1 year, it is subject to short term capital gain tax which is added to your overall income and attracts the tax rate applicable to your highest tax slab. If you sell them after 1 year, it attracts Long Term Capital Gain tax (10% without indexation or 20% with indexation). Dividend on Liquid fund is tax free in the hands of investor, however the fund house shall deduct upfront divided tax of 28.3%.
I am a strong believer of the saying that money creates money. If you have idle funds, why not put them to work in a liquid fund and earn higher returns rather than leaving them in a saving account which would earn a mere 4% interest. And the best part it is that you get returns of Fixed deposits with a liquidity and security of a saving account. What else could you ask for !