You can instantly redeem your investments in liquid funds subject to a maximum of ₹50,000 per day based on the recent changes made by the capital market regulator. Is this enhanced liquidity compelling enough for you to invest in liquid funds? We show why liquidity is not the only factor you should consider while investing in liquid funds! We then show why savings account is a worthy alternative.

Liquidity factor

There are two important reasons why you should invest in liquid funds. For one, you could use liquid funds to park tactical cash. Suppose you are selling some of your equity investments.

You may prefer to hold cash for some time before reinvesting in the stock market. This cash you hold for reinvesting is called tactical cash.

As an individual investor, holding tactical cash means keeping the money in your savings account. You may instead choose to temporarily invest the sale proceeds in liquid funds. The advantage? The post-tax returns on liquid funds are marginally higher than savings account interest rate. Also, the recent change by SEBI makes it easy for you to shift your money from a liquid fund back to the equity market.

For another, you may use liquid funds to maintain your contingency cash for medical emergencies. This emergency fund can also help during temporary loss of income. The advantage of investing in a liquid fund is that it offers the same liquidity, and can generate higher returns than savings bank account.

So, it appears that liquid funds score marginally over savings based on returns, with similar level of liquidity. Should you, therefore, choose liquid funds to park your contingency money and tactical cash?

Safety too

We believe that you should keep contingency money in your savings account! Why? Besides liquidity, you should consider protecting the nominal capital of your contingency money; returns are secondary. Here is the issue. The computation of net asset value (NAV) for liquid funds is based on the funds’ investment composition.

Liquid funds that invest in securities with maturities above 60 days have to mark-to-market their NAV. Whereas liquid funds that invest in securities with maturities of 60 days or less use accrual basis of valuation; these funds simply add the interest earned to the portfolio value.

What if the RBI increases interest rates? This would cause the mark-to-market NAV of a liquid fund to decline in value if it has investments in securities above 60 days. This means your contingency fund’s nominal capital is not protected! You may argue that choosing a liquid fund that invests in instruments less than 60 days will resolve this issue. Unfortunately, it is for the fund manager to decide where to invest. What if the fund manager buys securities that are marked-to-market after you invest in the liquid fund? Can you continually monitor the liquid fund to check its portfolio composition?

Therefore, we suggest you choose savings account over liquid funds. You can enhance returns on your contingency fund by keeping 50 per cent of the amount in savings account and the rest in fixed deposits with a bank that does not levy premature withdrawal penalty.

What about tactical cash? You can use savings account to park your tactical cash as well! Why? You will primarily hold tactical cash as part of your satellite portfolio to profit from short-term fluctuations in the stock market.

So, you may have to frequently shift between liquid fund and your satellite portfolio during a year. What if your satellite portfolio does not have a large corpus? Then, investing in liquid funds instead of keeping the money in savings account may not offer sizable additional gains for the efforts you take. Finally, liquid funds attract higher taxes, whereas annual interest income from savings account is exempt up to ₹10,000.

The writer is the founder of Navera Consulting. Send your queries to portfolioideas@thehindu.co.in

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