Liquidity in Investments – What is it?

We all know what liquidity means, in the context of investments: something that can be easily availed of when you require money i.e. how easily and how quickly it can be converted to cash / cash equivalent. However, there is one more aspect to it, apart from conversion to cash.

That is, to what extent your returns are impacted due to early withdrawals. Let’s understand this.

Certain investments in the market are affected by market fluctuations. Hence, if, on your day of withdrawal, the market is down, you’ll receive an unfavourable amount. Similarly, if the market has seen a favourable upward movement, on your day of withdrawal, you’ll receive a higher amount. To summarise, your withdrawals will always depend on the market conditions, at that particular time. This is majorly seen with equity-based investments, where the market is although liquid but unstable.

To be noted, this volatility tends to even out over a long period of time, because you are giving that much time to that market. If you are not sure when you would require that money, then you are open to market movements. If you do not want your money to be open to market movements, then you have to put it in an avenue that is stable i.e. subject to minimal volatility. What, then, is stable?

In the mutual fund space, there is a fund category called Liquid Funds, colloquially also known as cash funds. And these are stable. Only in very rare occasions are Liquid Funds subject to market volatility. These funds invest in short maturity money market instruments, issued by companies and banks. The portfolio maturity i.e. the weighted average maturity, of all the instruments in the portfolio of a Liquid Fund, is usually one to two months, up to a maximum of three months. This makes it stable i.e. the returns from Liquid Funds normally look like a straight line, not like returns from equity-oriented funds, which look like an ECG report.

There is another recently-introduced category called Overnight Fund, which has maturity of one day only and is even more stable than Liquid Funds. However, this category is available with only a few mutual fund houses and is gradually gaining in acceptance. As and when it becomes widely available, you can invest in these funds for very stable returns.

If you keep your money in bank deposits, that also is liquid as you can easily and quickly withdraw that money and use it. However, there may be a premature withdrawal penalty on your bank deposit i.e. you would get lower returns than contracted. In mutual funds, there may be exit load in some categories of funds, but it is not there in Liquid Funds.

Net-net, as long as you are parking your money in Liquid Funds, you are putting it in a stable-return avenue.

Joydeep has worked in the financial services industry for 25 years, of which his last 13 years were spent in the Wealth Management department of BNP Paribas. He is a regular contributor to the publications like Mint, Financial Express, MoneyControl, DNA, Cafemutual, etc. He is a Certified Financial Planner and has done trainings for CRISIL, FPSB, NISM. Joydeep is also the author of 4 well-received books.