Liquid funds are typically used by investors to park their emergency corpus. Liquid funds invest in money market instruments up to 91 days maturity. These funds are typically accessible within T+1 days
Is it worth moving back to traditional investment instruments?
Double-digit returns in debt mutual fund schemes have declined in the last one year. The one-year returns of liquid funds and overnight funds have, in fact, fallen to 3 per cent lower than the interest offered by banks on savings accounts. In such a scenario, some mutual fund investors are reviewing the option to move to bank FDs to earn slightly higher returns on their short term investments. But is it worth moving back to traditional investment instruments? Or, is there any better option to invest your money for a short time period?
Since 2019, the RBI has cut the policy rate sharply (250 bps) and announced a slew of measures to support the COVID-led slowdown in the economy, which has pulled down the returns of short duration debt funds over the past year.
“The measures announced along with abundant liquidity in the banking system resulted in yields falling across the yield curve, particularly at the shorter end. This sharp fall is also reflected in the yield to maturity of funds across the shorter duration spectrum,” says Dhaval Kapadia, Director – Managed Portfolios, Morningstar Investment Adviser India.
Liquid funds are typically used by investors to park their emergency corpus. Liquid funds invest in money market instruments up to 91 days maturity. These funds are typically accessible within T+1 days.
Liquid funds, a better option to park emergency fund
Bank FDs upto six months are offering slightly higher returns of around 4 per cent, which can look attractive at this time as compared to liquid funds. But, mutual fund experts still favour liquid funds in terms of liquidity and post tax returns. They say post-tax returns on very short tenor FDs (<6 months) are somewhat comparable to YTMs on liquid funds, investors deciding between liquid funds and bank FDs should consider their liquidity needs, investment horizon and applicable taxation.
“Unlike bank FDs, liquid funds have no lock in and are more tax efficient, in the long term,” says Priti Rathi Gupta, Founder, LXME. Rathi explains, a fixed deposit attracts tax every year on the interest received whereas one needs to pay tax on liquid mutual funds only upon selling their units and incurring capital gains. In case, the emergency fund remains unused for a long term, investors will cherish a lower taxation in liquid or overnight funds upon redeeming after three years.
Long-term capital gains in debt funds are taxed at a flat rate of 20 per cent after providing for indexation. Whereas, in case of a bank FD, the long term gains will be taxed at the applicable income tax slab rate.
Short-term capital gains in case of a bank FD or debt funds are added to the income of the investor and taxed as per applicable slab rate.
Look at real rate of return
Mutual fund managers urge investors to look at real rate of return on their investments. They believe comparing historical returns will not let investors invest. We should not get anchored at historical returns, they say.
“20 years back when liquid funds were giving 8 to 9 per cent, even inflation was 9 to 10 per cent. So, my real return was zero. Today again, when liquid funds are giving 3 or 4 per cent, bond funds are giving 5 per cent, inflation is at 4 per cent. As an investor, we need to learn to look at our real rate of return. The return net of inflation is what we are earning,” says Kalpen Parekh, President, DSP Mutual Fund.
As per Kalpen Parekh, in fixed income, if you are able to remain 1 to 2 per cent positive over inflation, that should be good for investors to look forward.
Arbitrage Funds: An alternative to liquid funds
As an alternative to liquid funds, if you have three to six months of time horizon, mutual fund experts ask investors to consider investing in arbitrage funds. These funds typically buy equities and sell an equivalent value in futures of respective shares purchased. Since all equity positions are fully hedged, market risk is largely eliminated. Arbitrage funds score over liquid funds in terms of taxation.
“Arbitrage funds are classified as equity for taxation purposes,” says Dhaval Kapadia. As per him, the returns on such funds would be similar to those on liquid funds but since equity taxation is applicable, post tax returns would tend to be higher vis-a-vis liquid funds, particularly for investors taxed at 20 per cent or higher rates.
While short term capital gains in debt funds are taxed as per applicable tax slab rate of the investor, short term capital gains in equities are taxed at 15 per cent.
As per Kalpen Parekh, arbitrage funds are proxy to 1-2 month investing with better tax efficiency.
Arbitrage funds in the last one year have given an average return of close to 3 per cent.