What Are The Differences Between Liquid Funds And Equity Funds?
If you're new to mutual fund investing, one common question you'll face is: Should I invest in liquid funds or equity funds? While both are mutual fund categories, they serve very different purposes in a financial plan. Understanding the difference between equity and liquid funds is essential so you can align your investment with your financial goals, risk tolerance, and time horizon.
Although both types of funds fall under the mutual fund umbrella, they are quite different in nature. One is meant for capital preservation and liquidity, while the other is aimed at wealth creation through market-linked returns. Let’s explore each in detail to understand where and when to use them.
What are Equity Funds?
Equity funds are mutual funds that primarily invest in the stock market. These funds allocate a majority of their portfolio (usually 65% or more) towards equities or shares of publicly listed companies. Equity funds are ideal for long-term wealth creation but come with market risks.
Features of Equity Funds:
- Return Potential: High, but not guaranteed. Returns depend on market performance and fund management.
- Investment Horizon: Best suited for long-term goals (5+ years) like retirement, children’s education, or wealth accumulation.
- Risk Level: High due to stock market volatility.
- Taxation: If held for more than 1 year, taxed at 12.5% on LTCG (long-term capital gains) tax on gains above ₹1.25 lakh. Short-term gains (<1 year) taxed at 20%.
Suppose you invest ₹1 lakh in an equity fund focused on large-cap companies. If the stock market performs well, your investment could grow to ₹1.5 lakh or more in 3 years. However, there's also a risk of value dropping during a market downturn.
Types of Equity Funds
Equity mutual funds come in various types based on the size of companies they invest in, their investment strategy, or sector focus. Here are the most common ones:
- Large-Cap Funds: These invest in well-established companies with a strong market presence. They are relatively stable and suitable for conservative equity investors.
- Mid-Cap Funds: These target mid-sized companies with growth potential. Returns can be higher than large-caps, but they carry more risk.
- Small-Cap Funds: Invest in smaller, emerging businesses. These funds are highly volatile but can offer substantial long-term gains.
- ELSS (Equity Linked Saving Scheme): Offers tax benefits under Section 80C and has a lock-in period of 3 years. Ideal for long-term tax-saving investors.
- Sectoral/Thematic Funds: Focus on specific industries like IT, pharma, or energy. These can be risky if the sector underperforms.
What are Liquid Funds?
Liquid mutual funds are a type of debt fund that invests in very short-term fixed-income instruments like treasury bills, commercial papers, and certificates of deposit. These funds are designed for capital preservation and high liquidity.
Additional Read: What are Liquid Mutual Funds?
Features of Liquid Funds:
- Return Potential: Moderate and more stable than equity funds.
- Investment Horizon: Ideal for short-term parking (a few days to 3–6 months).
- Risk Level: Low (but not zero), as they are exposed to interest rate and credit risks.
- Taxation: Gains are taxed based on the investor’s income tax slab, irrespective of the holding period.
Say you receive a bonus of ₹50,000 but don’t need it for a few months. Parking it in a liquid fund could give you better returns than a savings account, without locking your money.
Types of Liquid Funds
Liquid funds primarily differ based on the short-term debt instruments they invest in. All aim for safety and liquidity, but here's how they vary:
- Overnight Funds: Invest in securities that mature within a few days. Ideal for parking funds very temporarily — safe and ultra-liquid.
- Liquid Funds: Invest in instruments with a maturity of up to 91 days. These are best for holding money for a few days to months with low volatility.
- Ultra Short Duration Funds: Invest in debt instruments with maturities of 3–6 months. Slightly higher returns than liquid funds but with marginally more risk.
Comparison Between Liquid Fund and Equity Fund
After understanding each fund type separately, let’s compare them side by side.
Key Differences Explained:
- Objective: Equity funds aim for long-term wealth creation by investing in stocks. Liquid funds focus on short-term capital safety and quick access to funds.
- Returns: Equity funds can deliver higher returns but are unpredictable. Liquid fund returns are stable but generally lower.
- Risk: Equity funds are subject to high market volatility. Liquid funds are considered safer, though not risk-free.
- Liquidity: Both offer liquidity, but liquid funds often allow same-day or next-day redemption without exit loads (after 7 days).
- Investment Period: Choose equity funds for long-term goals and liquid funds for short-term needs.
- Taxation: Equity fund taxation is based on the duration of holding. Liquid fund gains are added to your income and taxed as per your tax slab.
Liquid Funds vs Equity Funds: Detailed Comparison Table
Feature | Equity Funds | Liquid Funds |
Primary Investment | Stocks / Equities | Short-term debt instruments |
Return Potential | High (market-dependent) | Moderate (interest-rate linked) |
Risk Level | High (market volatility) | Low (interest rate & credit risk) |
Ideal Investment Horizon | Long-term (5+ years) | Short-term (few days to 6 months) |
Liquidity | Moderate (T+1 or T+2 settlement) | High (often same-day or next-day) |
Tax on Short-Term Gains | 20% (if sold within 1 year) | Taxed as per income slab |
Tax on Long-Term Gains | 12.5% above ₹ 1.25 lakh (after 1 year) | Taxed as per income slab |
Exit Load | Usually before 1 year (varies by fund) | No load after 7 days |
Suitable For | Wealth creation, long-term goals | Emergency fund, idle cash, short goals |
How Risky Are Liquid vs. Equity Funds?
Risk is a major deciding factor when choosing between these two categories. Let’s explore how the risks differ:
Equity Fund Risks:
- Market Risk: Prices of shares fluctuate due to economic conditions, news, and global events.
- Volatility: Equity NAVs can move up or down quickly based on prevailing market conditions.
- Not Capital Protected: In a worst-case scenario, you could get back less than you invested.
Liquid Fund Risks:
- Interest Rate Risk: Bond prices fall when interest rates rise.
- Credit Risk: Slight possibility that a debt instrument issuer may default on repayments.
- Lower, but Not Zero Risk: Safer than equities but not as safe as a bank deposit.
If you're uncomfortable with daily NAV fluctuations, liquid funds are safer. If you're okay riding market waves for higher growth, equity funds are better suited.
Which is Preferable: Liquid Funds or Equity Funds?
The choice depends entirely on your financial objective, risk tolerance, and investment horizon.
Choose Liquid Funds If:
- You need to park money temporarily, such as emergency funds or surplus cash.
- You want capital preservation and high liquidity.
- You plan to use the money within a few weeks or months.
Choose Equity Funds If:
- You have long-term financial goals like buying a house, building retirement corpus, or funding education.
- You can tolerate market ups and downs and stay invested for 5+ years.
- You want your money to outpace inflation and grow significantly over time.
Conclusion
Understanding the difference between equity and liquid funds helps you make better investment decisions. While liquid mutual funds offer safety and short-term flexibility, equity funds provide the potential for long-term growth, but with higher risk.
There’s no “better” fund type universally. The right fund depends on your specific needs, time frame, and risk appetite. Many smart investors use both: liquid funds for near-term goals and emergencies, and equity funds for long-term wealth creation.
If you're just starting, assess your goals carefully and consider consulting with a financial advisor. Whether you invest in liquid fund options or choose equities, aligning your choice with your financial plan is key.
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FAQ
What is the main difference between equity and liquid funds?
The key difference between equity and liquid funds lies in risk and investment horizon. Equity funds invest in stocks for long-term growth, while liquid funds invest in short-term debt for capital preservation and liquidity. Liquid funds are safer; equity funds offer higher potential returns.
Are liquid mutual funds completely risk-free?
Liquid mutual funds carry minimal risk but aren’t entirely risk-free. They invest in short-term debt instruments, so interest rate or credit events can slightly affect returns. Still, they’re much safer compared to equity funds and ideal for short-term or emergency fund needs.
When should I invest in liquid funds vs equity funds?
Invest in liquid funds when you need to park money for a few days to months or build an emergency fund. Choose equity funds if your goal is long-term wealth creation and you can stay invested for 5+ years to manage volatility.
Do liquid funds offer better returns than savings accounts?
Yes, liquid mutual funds often offer slightly higher returns than regular savings accounts, while still maintaining high liquidity and low risk. However, they are not guaranteed and may fluctuate a bit depending on market conditions.
Can I lose money in equity funds?
Yes, since equity funds invest in the stock market, they are subject to market fluctuations. While they offer high return potential, they can also experience losses in the short term. A longer time horizon helps manage this risk.
Are liquid funds suitable for beginners?
Yes, liquid mutual funds are ideal for beginners who want to start with low-risk investments. They are also useful for managing idle funds, parking emergency savings, or investing temporarily before moving into higher-risk options like equity funds.
How is liquidity different in liquid vs equity funds?
Liquid funds allow easy redemption with money often credited within 24 hours. Equity fund withdrawals can take 2–3 business days and may involve exit loads or capital gains tax, making them less liquid than liquid mutual funds.
Which is better for tax-saving: liquid or equity funds?
ELSS (Equity Linked Saving Scheme) is an equity fund that offers tax benefits under Section 80C. Liquid funds do not provide any tax deductions. So, if tax-saving is your goal, equity funds are a better choice.
What are the returns like in liquid funds vs equity funds?
Liquid fund returns generally range between 3%–6% annually with low risk. Equity fund returns can range from 8%–15% or more in the long run but come with high volatility. Return potential is higher in equity funds if you're patient.
Can I include both liquid and equity funds in my portfolio?
Yes, a balanced portfolio often includes both. Use liquid funds for short-term needs or cash management, and equity funds for long-term growth. This helps with diversification and aligns investments with your goals and risk appetite.