Liquid Funds or Liquid ETFs? Understand the Differences Before Investing

For investors looking to earn returns on idle cash without taking significant risks, liquid funds and liquid exchange-traded funds (ETFs) are among the most popular options in India. Both investment avenues offer high liquidity and relatively low risk, making them ideal for short-term fund parking. However, understanding the differences between liquid funds and liquid ETFs is crucial for making an informed decision. This guide delves into their features, benefits, taxation, and suitability for different investors in the Indian financial landscape.

What Are Liquid Funds?

Definition and Characteristics

Liquid funds are a type of mutual fund that primarily invests in short-term, high-liquidity debt instruments. The primary goal is to ensure capital safety while offering reasonable returns. These funds typically invest in:

• Treasury Bills (T-Bills)
• Commercial Papers (CPs)
• Certificates of Deposit (CDs)
• Collateralized Lending and Borrowing Obligations (CBLO)

The maturity period for these instruments is usually up to 91 days, reducing interest rate volatility risks.

Key Benefits

1. Low Risk: Due to their short maturity, liquid funds are relatively immune to interest rate fluctuations.
2. Quick Redemption: Most liquid funds follow a T+1 settlement cycle, with some offering instant redemptions.
3. Flexible Investment Tenure: No lock-in period; investors can exit anytime, though an exit load may apply within the first seven days.
4. Higher Returns than Savings Accounts: Typically, liquid funds offer better yields compared to regular savings accounts.
5. Ease of Investment: Investors can purchase liquid funds via mutual fund platforms, banks, or financial apps.

What Are Liquid ETFs?

Definition and Characteristics

A liquid ETF (Exchange-Traded Fund) is a type of mutual fund that invests in short-term debt securities or money market instruments, similar to liquid funds. However, unlike traditional mutual funds, liquid ETFs trade on stock exchanges, allowing investors to buy or sell units at market prices during trading hours.

Key Benefits

1. Intraday Liquidity: Investors can buy or sell at real-time market prices, unlike liquid funds, which settle at the next day’s Net Asset Value (NAV).
2. Lower Expense Ratio: Liquid ETFs generally have lower costs compared to liquid mutual funds.
3. No Exit Load: Since liquid ETFs are traded on the exchange, there are no early redemption penalties.
4. No Securities Transaction Tax (STT): Liquid ETFs do not attract STT, making them a cost-effective choice.
5. Better Utilization for Stock Market Investors: Investors can park idle trading capital in liquid ETFs, ensuring continuous fund utilization.

Key Differences Between Liquid Funds and Liquid ETFs

Taxation Rules for Liquid Funds and Liquid ETFs in India

Liquid Funds Taxation

1. Short-Term Capital Gains (STCG): If held for less than three years, gains are taxed as per the investor’s income slab.
2. Long-Term Capital Gains (LTCG): If held for over three years, gains are taxed at 20% with indexation benefits.

Liquid ETFs Taxation

1. Short-Term Capital Gains (STCG): If held for less than one year, gains are taxed at 15%.
2. Long-Term Capital Gains (LTCG): Gains exceeding ₹1 lakh in a financial year are taxed at 10% without indexation benefits.

Who Should Invest in Liquid Funds?

Liquid funds are ideal for:

• Conservative Investors: Those looking for safe, short-term investments with stable returns.
• Emergency Fund Holders: A great alternative to savings accounts due to better returns and instant liquidity.
• Short-Term Investors: Ideal for investors with a 1-3 month horizon.
• Pre-Equity Investment Parking: Investors waiting to enter equity funds can first park funds in liquid funds for steady returns.

Who Should Invest in Liquid ETFs?

Liquid ETFs are best suited for:

• Stock Market Investors: Those actively trading in stocks can efficiently utilize their idle cash.
• Investors Seeking Intraday Liquidity: Ideal for those who need real-time access to funds.
• Cost-Conscious Investors: With lower expense ratios and no STT, liquid ETFs are cost-effective.
• Short-Term Fund Parking: Those who wish to maximize returns on temporary funds without additional risk.

Liquid Funds vs. Liquid ETFs: Which Is Better?

Choosing between liquid funds and liquid ETFs depends on your investment goals and financial preferences:

• For ease of access and flexibility, liquid funds are a better option. They do not require a Demat account and can be managed through mutual fund platforms.
• For real-time liquidity and cost efficiency, liquid ETFs are preferable. They are best suited for stock market participants who need instant access to their funds.

Final Verdict

Both liquid funds and liquid ETFs offer high liquidity and safety, making them viable options for short-term investments. However, the right choice depends on whether you prioritize convenience (liquid funds) or cost-efficiency with real-time liquidity (liquid ETFs). Evaluate your financial goals and risk appetite before investing to maximize returns while ensuring liquidity.

Conclusion

In the Indian financial landscape, liquid funds and liquid ETFs serve as excellent short-term investment avenues. While liquid funds are simpler and more accessible for traditional investors, liquid ETFs cater to stock market participants needing quick fund mobility. By understanding their features, benefits, taxation, and costs, investors can make informed decisions that align with their financial needs. Whether you choose liquid funds or liquid ETFs, both options ensure capital preservation while generating returns on idle cash.