A Liquid Mutual Fund is a type of debt fund that invests in fixed-income instruments such as commercial paper, government securities, and treasury bills, with maturities of up to 91 days. The net asset value (NAV) of a liquid fund is calculated daily, for all 365 days of the year. In contrast, equities are among the most liquid asset classes. However, not all equities or fungible securities have the same level of liquidity. Some options and stocks are traded more actively on stock exchanges, leading to greater market availability and liquidity for those assets.
Mutual fund investments cater to varying financial goals and risk tolerance levels, and equity and liquid funds have traditionally been the top-performing assets with unique properties. Investors aiming to maximise returns must understand what distinguishes equity and liquid funds.
In this article, we will explain the differences between equity and liquid funds with respect to their features, risks involved, and taxation for better investment decisions.
What is the meaning of equity funds?
Equity funds mostly invest in stocks of different companies. These funds aim to grow your capital investment over a long period. You need to have a high-risk tolerance level and a long investment horizon—generally around five years or more—for these funds to reach their full potential.
Equity fund types like large-cap, mid-cap, small-cap, sectoral, and diversified funds can be selected with different levels of risk and reward. Investing in equity funds allows you to benefit from the growth of underlying companies. However, you should be prepared for market volatility.
What is the meaning of liquid funds?
Liquid funds or money market funds are debt mutual funds that invest in very short-term, negligible-risk investment tools like treasury bills, commercial paper, and a certificate of deposit (CD). Investors use these funds to store excess cash and earn respectable returns. Liquid funds are suitable for investments up to 3-6 months, making them less risky and more liquid, which is great for emergency funds or short-term financial goals. They do not experience the same amount of volatility as equity funds.
Comparative analysis of equity vs liquid funds
| Feature | Equity Funds | Liquid Funds |
| Investment Horizon | Long-term (5+ years) | Short-term (a few days to a few months) |
| Risk Level | High (market volatility) | Low (stable returns) |
| Returns | High potential returns | Modest, stable returns |
| Liquidity | Moderate (may involve exit loads) | High (quick access to funds) |
| Taxation | Short-term: 20%Long-term: 12.5% over Rs. 1.25 lakh | Short-term: As per tax slabLong-term: 12.5% over Rs. 1.25 lakh |
| Ideal for | Growth-oriented investors with a high risk tolerance | Conservative investors looking for capital preservation |
| Types | Large-cap, mid-cap, small-cap, sectoral, diversified | Money market instruments, treasury bills, commercial paper |
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Equity vs Liquid funds - How risky are they?
Both equity and liquid funds serve different investor profiles because the risk levels of both are incomparable. Equity funds are inherently more risky because of their involvement in the stock market. When stocks rise or fall sharply and with significant changes in market conditions, economic factors, and corporate performance, the value of equity funds fluctuates. With equity funds, investors must be ready to endure periods of volatility and possibly short-term losses. However, in the long term, equity funds have proven to provide substantial returns. Hence, they are suitable for aggressive risk-takers and investors with a longer investment horizon.
Liquid funds, on the other hand, are more of a stability and safety proposition. These funds invest in low-risk or less liquid short-term debt instruments. Hence, liquid funds have a lower risk profile and provide an element of predictability or stability to return on investment. Liquid funds carry an interest rate risk, which can affect returns if the rates change. But then again, this risk is relatively less than the risks involved with equity funds. These funds are ideal for cautious investors who want to protect their capital and hold liquidity due to immediate financial requirements.
Difference between taxation of equity vs liquid funds
One of the most important points to consider before investing in equity and liquid mutual funds is how they are taxed. Based on their holding period, they are both taxed differently. Short-term capital gains (STCG) earned on equity funds, which are realised within one year, are taxed at 20%. Long-term capital gains (LTCG) earned on equity funds, realised on holding the investment for more than one year, are taxed at 12.5% for gains exceeding Rs. 1.25 lakh per annum (financial year). As per the current taxation structure and laws, long-term investments in equity funds are incentivised.
Comparatively, there is a different tax treatment for liquid funds. If realised within three years of buying the units, short-term capital gains in liquid funds are taxed according to the investor's income tax slab rate. Long-term capital gains are taxed at 12.5 per cent with indexation benefit if investments in a liquid fund have been held for over three years. Indexation adjusts the purchase price of the investment for inflation, which effectively lowers the taxable capital gains. This makes liquid funds a tax-efficient alternative for long-term investments, though they normalise in diversified uses of short-term finance.
Which is better between equity vs liquid funds?
Your financial goals, appetite for risk, and investing horizon determine whether you should invest in equity or liquid funds. Equity funds are designed for investors who want to hold on to their investments in the longer term and can take a lot of risk from financial market uncertainty. These funds offer the opportunity to acquire massive rewards but come with a bigger risk.
Liquid funds would be suitable for risk-averse investors holding surplus funds who seek low returns and easy access to their cash with the least amount of risk. They offer fixed returns and high liquidity and can be used for short-term financial goals or emergencies. Finally, a balanced portfolio can profit from an allocation in equity and liquid funds as it would reduce risk levels while maximising returns.
Conclusion
You need to have a thorough understanding of equity vs. liquid funds to make better investment decisions. While equity funds offer potentially higher returns for long-term growth, they also have a high amount of associated risks. On the other hand, investing in liquid mutual funds offers stability and allows you to withdraw your money at the exit price whenever the need arises. You simply need to align your financial goals, risk-taking capacity, and investment timeframe, and you can add the right blend of equity and liquid funds.
