The Nuances of Liquid and Liquid Plus Funds
July 10, 2011 1 Comment
Mutual fund schemes known as liquid funds /money market funds/cash funds and ultra short-term bond funds/liquid plus funds are options for parking funds for the short term.They allow for a high degree of liquidity.They are alternatives to keeping money in a savings bank account or a short term bank fixed deposit.
Liquid funds invest in money market instruments of residual maturity up to 91 days.Liquid funds have the lowest volatility in returns among all categories of mutual funds because there is there is no mark-to-market (MTM) valuation of the portfolio on a daily basis unless there is a trade in the secondary market in the underlying security .Practically there is no trade in money-market instruments and valuation of daily NAV happens on an accrual basis, i.e., by adding the coupon accrued for the day without any mark-to-market impact.
Ultra short-term bond funds (USTBs) are defined as debt funds in the offer document and the fund manager is free to take securities of maturity longer than 91 days, but there is no compulsion to do the same.Valuation of daily NAV happens as per the valuation matrix provided by the rating agencies, hence there could be a mark to-market impact. However, the component of securities with residual maturity more than 91 days (for which the valuation matrix is published) is maintained on the lower side, so that the volatility in returns is limited. Returns in USTBs are marginally higher than liquids by virtue of the marginally higher portfolio maturity.
Normally, the longer the maturity of the instrument, the higher is the yield on that instrument (time value of money). USTBs have the liberty to purchase securities with maturity of more than 91 days and on an average, the portfolio maturity is longer than liquid funds. This leads to a higher accrual rate on the portfolio of USTBs. The volatility of returns in USTBs is marginally higher than liquids funds due to the small MTM component.
In liquid funds, purchase is T-1, i.e., cleared funds are given to the AMC by the cut-off time of 2 pm and availing of previous day’s NAV. Redemption is T+1, i.e., the redemption request is placed within the cut-off time of 3 pm and the proceeds are received the next day.
In USTBs, purchase is on a T+0 basis, i.e., that day’s NAV would be applicable. If the amount is more than Rs 1 crore, clear funds have to be given to the AMC by the cut-off time of 3 pm, otherwise the NAV of the day on which clear funds are being given will be applicable. Redemption is T+1 for USTBs as well. For both fund categories the application should be submitted and time stamped at the AMCs’/RTA’s office within the cut-off time.
The investor can invest in either the growth or dividend option. In case of growth, the tax treatment of these schemes is on par with that for bank fixed deposits, where the income generated is added to the investor’s income and taxed according to the tax slab.While dividends are tax-free in the hands of the investor, there is a dividend distribution tax (DDT) that is deducted by the AMC on behalf of the investor and passed on to the government. The rate of DDT in case of liquid funds is 25% (plus surcharge/cess)for individuals and the DDT rate for corporate investors is 30%. In case of USTBs, there are two rates of DDT: for individual investors, it is 12.5% (plus surcharge/cess) and for corporate investors the rate is 30% (plus surcharge/cess).
The advantages of liquid funds are that they provide stable returns and T-1 purchase. Another advantage is the declaration of NAVs on Sundays/holidays as well, which means redemption request put in on Friday (within the cut-off time) for proceeds on Monday would be at Sunday’s NAV. In USTBs, this redemption will take place at Friday’s NAV (since there is no NAV on holidays), which means no accrual income for two days.
The advantages of USTB funds are marginally higher returns than liquid funds and tax efficiency over liquid funds, i.e., lower DDT rate for individuals.
For a horizon of more than two weeks,(ideally2-4months)investors can avail of the relatively higher returns and tax efficiency of USTBs and for a short horizon of a few days, liquid funds are safer.
Both the fund categories can be used for systematic investments into equity funds.Liquid schemes do not charge any exit load from its investors. While most ultra short-term schemes have done away with these charges, a few might still charge an exit load.Other charges are similar to what one would pay for any other mutual fund scheme.