How to Assess the Liquidity of a Mutual Fund Scheme? 

Liquidity in mutual funds determines how quickly and easily an investor can convert their mutual fund holdings into cash without significantly impacting the fund's value. For investors in India, where financial goals often align with specific timelines, understanding the liquidity of mutual fund schemes is essential to ensure that investments can be accessed when needed.

What is Liquidity in Mutual Funds? 

In finance, liquidity refers to the ease and speed with which an asset can be converted into cash without significantly affecting its market price. When applied to mutual funds, liquidity denotes how quickly and efficiently investors can redeem their fund units for cash, considering any associated costs or penalties.​

Mutual funds pool money from multiple investors to purchase a diversified portfolio of securities, such as stocks, bonds, or other assets. As a result, the liquidity of a mutual fund is influenced by the liquidity of its underlying assets. For instance, funds investing in highly liquid assets like government securities or large-cap stocks typically offer higher liquidity to investors. On the other hand, funds holding assets like real estate or micro-cap stocks may exhibit lower liquidity due to the inherent challenges in quickly selling such assets without impacting their prices.​

It's important to note that mutual funds are generally open-ended, allowing investors to buy or redeem units at the fund's Net Asset Value (NAV) at the end of each trading day. This structure provides a level of natural liquidity, but the actual ease of redemption can vary based on the fund's asset composition and market conditions.

Why is Liquidity Important in Mutual Fund Investments?

Imagine an investor, Achla, who has invested ₹5 lakh in two different mutual funds:​

1. Fund A: A liquid mutual fund that primarily invests in short-term government securities and high-rated corporate bonds.​
2. Fund B: A sectoral equity fund focusing on micro-cap technology companies.​

Now, she faces an unexpected medical emergency and needs ₹2 lakh immediately.​ Here’s what’s likely to happen:

Assessment:

• Fund A: Given its investment in highly liquid assets, Achla can place a redemption request, and the funds will typically be credited to her bank account within 1-2 business days. The transaction incurs minimal costs, and the NAV remains relatively stable due to the low volatility of underlying assets.​
  
   
• Fund B: This fund invests in micro-cap stocks, which may not have high daily trading volumes. Selling significant portions of these holdings quickly could impact their market prices. Additionally, during market downturns, the liquidity of such assets can further diminish. As a result, redeeming ₹2 lakh might take longer, and Achla could potentially face a lower NAV, reducing the amount she receives.

This example highlights the importance of understanding the liquidity profile of mutual funds. While both funds offer redemption options, the speed and efficiency of accessing funds differ significantly based on the underlying assets. To summarise the importance of liquidity in funds:

• Access to Funds: Investors may need to access their investments for emergencies, opportunities, or planned expenses. High liquidity ensures that funds are available when required.
• Flexibility: Liquid mutual funds provide the flexibility to reallocate investments in response to changing financial goals or market conditions.​
• Risk Management: Liquidity allows investors to exit positions in volatile markets, helping to manage potential losses.​
• Cost Efficiency: Highly liquid funds often have lower transaction costs, as buying or selling units doesn't significantly impact the fund's price.

Factors That Determine the Liquidity of a Mutual Fund Scheme 

There are several aspects that directly or indirectly influence the liquidity of a mutual fund scheme. Notable ones include:

• Underlying Assets: The liquidity of a mutual fund largely depends on the assets it holds. Funds investing in government securities or blue-chip stocks are generally more liquid than those investing in real estate or small-cap stocks.​
• Fund Size: Larger funds may have more diverse portfolios and better access to liquid markets, enhancing their overall liquidity.​
• Redemption Policies: Some funds have exit loads or lock-in periods that can affect liquidity. For instance, Equity Linked Savings Schemes (ELSS) have a mandatory three-year lock-in period.​
• Market Conditions: During market downturns, even typically liquid assets can become illiquid, affecting the fund's ability to meet redemption requests promptly.​
• Regulatory Guidelines: Regulatory bodies like SEBI in India set norms that influence fund liquidity, such as limits on sectoral exposure and requirements for holding liquid assets.

How to Assess the Liquidity of a Mutual Fund 

With so many mutual fund types and fund houses to choose from, assessing the liquidity of a fund can appear to be a complicated task. However, here are some best practices that can help you achieve this:

1. Review the Fund's Portfolio: Analyse the types of securities the fund invests in. A portfolio comprising high-quality, short-term debt instruments or large-cap stocks typically indicates higher liquidity.​
2. Check Redemption Terms: Understand the fund's redemption policies, including any exit loads, lock-in periods, and the time taken to process redemptions.​
3. Evaluate the Fund's Size and Holdings: Larger funds with diversified holdings may manage liquidity better. Also, assess the proportion of the fund invested in liquid assets.​
4. Monitor Market Conditions: Stay informed about market trends, as they can impact the liquidity of the fund's underlying assets.​
5. Consult Fund Ratings and Analyst Reports: Use resources from rating agencies and financial analysts to gauge the fund's liquidity profile.

Liquid Mutual Funds: A Highly Liquid Option

When it comes to liquidity in mutual funds, liquid mutual funds often top the list. These are specifically designed to provide investors with quick access to their money, making them one of the most flexible short-term investment options.

Liquid mutual funds mainly invest in short-term money market instruments such as Certificates of Deposit (CDs), Treasury Bills, Commercial Papers (CPs), and overnight securities. These instruments have a maturity of up to 91 days, which allows fund managers to maintain high liquidity and low interest rate risk. 

Why Are Liquid Funds Considered Highly Liquid? 

• Same-day or next-day redemption: Most liquid funds allow you to redeem your investment with the money credited to your bank account within one working day. Some even offer instant redemption up to a fixed limit through mobile apps.
• Low volatility: Since liquid funds invest in instruments with very short maturity periods, they are relatively stable and unaffected by market fluctuations or interest rate changes.
• No exit load: Many liquid funds do not charge exit loads if held for more than 7 days, making them ideal for investors who may need to withdraw funds unexpectedly.

Suppose you invest ₹1 lakh in a liquid fund. If an emergency arises after a week, you can redeem your units and receive the amount back by the next day, often with a small gain depending on interest rates. This makes them an excellent alternative to savings accounts for surplus funds.

Comparing Liquidity Across Different Mutual Fund Categories 

Not all mutual funds offer the same level of liquidity. While some allow for easy redemption and fast payouts, others can take days or even longer depending on the asset class and market conditions. Understanding how each category differs in liquidity can help you choose the right fund for your financial needs.

Liquidity Comparison by Fund Category:

• Liquid and Overnight Funds: These are the most liquid mutual fund types. You can typically redeem your money within just a few days. They are ideal for parking idle funds temporarily.
• Ultra Short-Term and Low Duration Funds:  These have slightly longer average maturities than liquid funds but still offer decent liquidity. Redemptions usually take 1–2 working days, and volatility remains low.
• Short-Term Debt Funds: While still relatively liquid, these funds may carry slightly more interest rate risk. Redemption proceeds typically reach your account in 2–3 working days.
• Equity Mutual Funds: While legally redeemable on any business day, equity funds depend on market trading and settlement. Redemption usually takes 3–4 business days, and market volatility can significantly impact the NAV on the day of exit.
• Thematic or Sectoral Funds: These funds invest in niche sectors which may not always be liquid. If many investors want to exit at once, the fund may face difficulties selling its holdings quickly without affecting prices.
• International Funds: These are often the least liquid due to different time zones, settlement periods in foreign markets, and regulatory processes. Redemptions can take longer than domestic funds.

Remember, liquidity in mutual funds doesn't just refer to how fast you can redeem your units, it also involves how quickly the underlying securities can be sold without incurring a loss. Always evaluate this aspect based on your investment horizon and financial goals.

Common Liquidity Risks and How to Avoid Them

Liquidity risk arises when a mutual fund is unable to meet redemption requests without significantly affecting its NAV. This often happens during market panics, credit events, or when too many investors redeem their units simultaneously. Being aware of such risks can help you avoid disruptions and losses.

Common Liquidity Risks:

1. Redemption Pressure: If many investors redeem at once, the fund may be forced to sell illiquid securities at a loss. This can reduce the NAV for remaining investors.
2. Exposure to Low-Rated Bonds: Funds that invest in BBB or lower-rated debt instruments may face trouble selling these securities during a crisis, which affects their ability to meet withdrawals.
3. Concentration Risk: If a fund has significant exposure to a single issuer or sector, any negative news about that segment can lead to a sharp fall in liquidity and performance.
4. Market Events and Crises: Situations like corporate defaults, banking sector instability, or regulatory clampdowns can instantly freeze liquidity in debt markets, affecting mutual funds that hold affected securities.

How to Avoid Liquidity Risk:

• Check the portfolio quality: Among debt funds, you funds that invest in high-credit-rated instruments and diversify across issuers and sectors have higher liquidity.
• Review the fund’s profile: Some AMCs disclose the inherent liquidity of their portfolio. Funds holding a large percentage in cash-equivalent assets are safer in terms of liquidity.
• Avoid chasing high yields: Higher returns often come from lower-rated or less liquid investments. Assess whether the extra return justifies the extra risk.
• Stick with established fund houses: Larger AMCs typically manage redemptions better due to better infrastructure, diversified investor base, and experienced risk management teams.

Conclusion 

Assessing the liquidity of a mutual fund scheme is crucial for making informed investment decisions, especially if you anticipate the need for timely access to your money. Liquidity reflects how quickly and easily you can redeem your mutual fund units without significant impact on value or returns. It is influenced by several factors, including the type of securities the fund invests in, the fund’s size, portfolio composition, and the market conditions.

While liquid mutual funds are specifically designed for quick access to funds, other categories like equity, thematic, or international funds may have longer redemption cycles and varying levels of liquidity risk. Credit quality, market depth, and the concentration of holdings also play a role in determining how easily a fund can meet large redemption requests without distress.

For investors, it’s important not just to pursue returns but to also evaluate how and when they might need to exit an investment. A fund with poor liquidity might trap your money during emergencies or cause unexpected losses during redemptions. Ultimately, striking the right balance between liquidity, returns, and risk will help you build a well-rounded investment portfolio.