How to select a Liquid Fund?

Over the past few years, we have seen debt mutual funds being promoted as a replacement for fixed deposits. I do not deny that there are a few clear benefits and debt mutual funds may provide better tax-efficient returns as compared to bank FDs.

However, the return of principal is more important than return on principal. And the events of the past few years (ILFS default recently, Ballarpur Default, Amtek Auto default) prove that debt funds have many risks that bank FDs don’t. Therefore, the investors must understand the risks associated with debt mutual funds before investing. Moreover, debt mutual funds come in multiple variants. Structurally, different variants will carry different levels of risk. Therefore, you need to select the right variant for you too.

In this post, let’s look at how to select a liquid fund. Before we move on to the selection process, let’s understand more about liquid funds.

What are Liquid Funds?

Liquid funds are a variant of debt mutual funds.

These funds invest in debt securities maturing in up to 91 days. Therefore, there is little interest rate risk i.e. the movement in interest rates won’t affect NAV of a liquid fund much. Therefore, liquid fund investments are not volatile.

Though liquid funds typically invest in very credit quality securities, the credit risk is still there. It is not very uncommon to see credit rating agencies (CRISIL, ICRA etc) err and the result is that high rated credit (even the best-rated credit like in case of IL&FS) does not have high creditworthiness. Essentially, the rating agencies can make a mistake of assigning a good credit rating to a bad company. By the way, the buck does not stop with the rating agencies. The fund manager must share some blame if a portfolio security defaults.

For more on interest rate and credit risk, refer to this post.

Most investors use liquid funds to select park short-term money or emergency funds. On redemption, you get the money the next business day. For redemptions up to Rs 50,000, you get the amount instantly in your bank account.

Liquid funds can be a replacement for savings bank account balance and short-term fixed deposits. The returns in liquid funds are not guaranteed and are market-linked.

Let’s look at how to select a liquid fund for you.

#1 Lower expense ratio is better

This is true for any debt mutual fund, not just liquid funds.

Debt mutual funds have limited scope for upside. After all, they earn through interest income and capital gains. And excess return can come only by taking an extra risk (mostly interest rate or credit risk).

In the case of liquid funds. higher returns are possible in two ways.

1. Cut down on expenses (or lower expense ratio)
2. Earn better returns. The only way to do that in case of liquid funds is to take a higher credit risk.

If the two funds are taking similar credit risk and interest rate risk, the returns should also be similar. In such a case, the fund expenses directly eat in your returns.

This is why it is better to go with funds with a lower expense ratio.

How to check expense ratios?

You can check on ValueResearch website.

#2 Go with the liquid funds with a large corpus

The bigger funds are likely to be more diversified. They may invest in a greater number of securities and have less concentrated exposure.

As mentioned above, liquid funds may not carry much interest rate risk but still carry credit risk.

The bigger funds are less likely to have, say 10% exposure to a single corporate.

If one of the securities (corporate) in the portfolio were to default, which fund will see a greater impact?

1. The one with 8% exposure to the security
2. The one with 2% exposure to the same security

Clearly, the one with the higher exposure.

In the case of the fund with 8% exposure, the NAV can go down by 8% (if there is a default). On the other hand, the fund with 2% exposure will go down by only 2%.

I am not saying 2% fall is good. Just that, it is better than an 8% fall.

I prefer liquid funds with at least Rs 10,000 crores AUM. I do understand liquid fund balances can go down very fast (because of heavy institutional investments that can go away really quickly) but a larger corpus is a good starting point.

#3 Avoid the funds with concentrated portfolios

This is in continuation of the earlier point.

It is better to avoid funds with concentrated portfolios, which are more likely in the case of smaller funds.

Let’s consider the portfolios of the two large liquid funds and two small liquid funds.

Clearly,  the funds with more concentrated portfolios will have a greater impact if one of their bigger investments were to get into trouble.

#4 Go with the bigger fund houses

Firstly, the bigger fund houses have a bigger reputation to manage. They may provide an exit to investors at a small loss.

For instance, Franklin AMC bought a troubled investment from one of its schemes in 2016. It is debatable whether such a move was investor friendly or not. However, the investors did get an exit from the bad investment. The smaller fund houses may simply not have the wherewithal to pull off such a thing. But yes, even a large fund house can’t help if too many companies default.

Secondly, the smaller funds may also have the tendency (not necessary though)to take greater risk to show better returns. They need that to attract funds.

As mentioned above, the better returns are possible in two ways.

1. Cut down on expenses (or lower expense ratio), which may be difficult for a smaller fund size.
2. Earn better returns. The only way to do that in case of liquid funds is to take a higher credit risk.

By the way, I have nothing against the smaller AMCs. Just that, I do not prefer smaller AMCs for my debt investments. This is not a problem in case of equity funds if these smaller AMCs have shown consistent performance.

Alternatively, you can look at the portfolios for the respective liquid funds and make an assessment about their credit risk. I must say it is not practical for a liquid fund may have hundreds of securities. However, in some cases, the portfolio choices may not be very difficult to understand.

For instance, let’s look at Quantum Liquid Fund. Quantum AMC is a small fund house. However, this fund invests only in Government Securities and commercial papers from PSUs (hence no credit risk). If you are looking for a safe liquid fund, this Quantum Liquid Fund is perhaps the safest choice (despite it being a small fund house).

The flip side is that the returns from this fund will be lower as compared to other funds in the same category (unless we start seeing system-wide defaults). Why? This is because the fund takes no credit risk. When there is no credit risk, there is no return spread that they earn.

#5 Do not simply chase the returns. May not be worth it.

In the case of liquid funds, there is not much upside. I compared the 1-year performance (as on October 27, 2018) of all the liquid funds.

If I exclude the three funds that experienced a default (Taurus, Principal Cash Management and Union), the best performer (Baroda Pioneer) gave 7.36% p.a. and the worst performer (Quantum Liquid) gave 6.38% p.a. By the way, we discussed earlier why Quantum gave lower returns.

In fact, only 5 funds (including the 3 funds that experienced defaults) returned less than 7.1% over the last one year. Between 7.1% and 7.36%, there is little sense in trying to be over-smart.

What should you do?

In my opinion, liquid funds are not the place to be cavalier. Liquid funds are a replacement for cash. There is little sense in shooting for the stars in case of liquid funds.

Pick up a liquid fund scheme (with a big corpus) from a bigger fund house and you should be just fine. If you want to dig deeper, opt for a lower expense ratio and less concentrated portfolios. Well, accidents can still happen but you get the odds in your favour.

If you are still having a problem in selecting the right funds for you, seek professional advice from a SEBI Registered Investment Adviser or a fee-only financial planner.

Additional Read

CapitalMind: Article on Taurus Liquid Fund and Ballarpur Default

Lessons to learn from Mutual Funds from Amtek Auto Default

MoneyLife: Run from Mutual Fund Schemes facing large redemptions