Prioritizing Liquidity over Returns: Why Investing in Liquid Mutual Funds is Crucial during Emergencies (2024)

Uncertainty is the only certainty in life. Emergencies arise when you expect them the least, impacting our financial well-being.

These financial emergencies can be in the form of unforeseen events like:

• income loss due to death of the primary breadwinner or loss of job,
• pay reductions,
• medical issues,
• natural disasters, etc.

All of these can hurt an investor’s financial stability.

The recent COVID-19 pandemic or the geopolitical tensions between Russia and the UK is a testimony to the unpredictable nature of the economy and all related financial investments, The best way to deal with such exigencies is to build an emergency fund. An emergency fund acts like a financial backup plan and works like a reset button to get one’s financial health back on track.

ET Spotlight

How much emergency money do you need?
An easy way to calculate how much one will need to set aside as an emergency fund is a simple formula –

Emergency Funds = X times Monthly Expenses
This formula is nothing but equal to 12 to 36 months' worth of regular monthly expenses, including EMIs.

Investors can consider the following checklist to finalize an investment avenue for building their emergency corpus:

In short, an investor can follow this checklist for building one’s emergency corpus:

• Liquidity: Liquidity refers to how quickly one’s investments can be converted to cash. Invest in instruments that do not have any lock-in period or high exit loads.
• Prioritize safety over returns: Avoid saving in instruments that have a high risk for capital erosion, instead, prioritize safety over returns.
• Low correlation with other asset classes: An investment portfolio has several asset classes, it's important to evaluate how the emergency fund fits in with the rest of one’s portfolio. Ideally, an investor needs to set it separate from the investments dedicated to long-term or short-term goals. This keeps investors from tapping into mutual funds reserved for long-term financial goals.
• Relevant to one’s risk appetite: Investors who are conservative and have a low threshold for risk might want to consider a higher sum dedicated to their emergency fund.

Investors can consider switching to Liquid Mutual funds for building their emergency corpus.

What are Liquid Mutual Funds?
As the name suggests, Liquid Mutual Funds allow investors flexibility to redeem and liquidate their investments depending on their needs. Liquid funds are a category of Debt mutual funds that typically invest in instruments having a maturity of fewer than 91 days, predominantly in short‐term debt and money market instruments such as government securities, repos, Certificate of Deposit, Commercial Papers, Treasury Bills (T-bills) with residual maturity of up to 91 days.

Are Liquid Mutual Funds Safe?
With this type of fund, investors can liquidate their investment at any time and can bank on the SLR philosophy (Safety, Liquidity over Returns). In short, such a fund generally prioritizes the safety and liquidity of one’s money over returns. They are relatively less risky compared to equity mutual funds.

ET Spotlight

A liquid fund is thought to be ideal for an emergency fund because it meets all the pre-requisites:

1. Reduces risk exposure and prioritizes liquidity
2. Brings stability to the portfolio.
3. Relatively Safer and Liquid amongst the debt mutual funds category

More importantly, during the quantitative tightening phase when central banks across the world are attempting to lower inflation rates. It can serve as an option to park short-term surplus cash lying idle in a Bank Savings Account with the potential to benefit from the rising interest rates.

When should investors invest in liquid funds?
It is important to have emergency funds or safe money such as liquid funds as a foundation of your portfolio qualifying as the safety building block in your portfolio. As a preliminary step before an investor thinks of investing in mutual funds for long- term goals, he/she needs to set aside the desired safe money for emergencies.

Advantages of investing in Liquid Funds

• Liquidity – Liquid funds offer flexibility to liquidate investments anytime. It is not relatively less sensitive to interest rate changes due to its short duration and is relatively less volatile than other types of mutual funds. For instance, Quantum Liquid Fund has an instant-redemption facility that allows immediate redemption of up to Rs.50,000 per day.
• Exit load – Liquid funds have no exit load on liquid funds after 7 days.
• Tax Benefits - Short-term capital gains (holding period of lesser than 3 years) are taxed per the income tax slab of the investor. The long-term gains earned on Liquid funds are more tax-efficient due to the indexation benefit.

How does one select the right Liquid Mutual Funds to invest in 2022?
When selecting Liquid Mutual Funds to invest in, assess whether it avoids investments in private entities or real estate, securitized paper to avoid any potential credit risk to one’s investment portfolio. Evaluate the quality of the underlying securities of your investment portfolio. Liquid funds generally endeavour to provide a high degree of liquidity. Investors should be cognizant of the underlying risk in the portfolio before they decide to invest.

Investors are cautioned not to take risks to try and earn that extra 0.5%-1.0% in their liquid funds. Liquid funds can be an option to savings bank accounts and the priority should be to invest in Liquid Funds, which keep investors’ money safe and liquid.

Quantum’s 12:20:80 Asset Allocation Strategy

As per Quantum’s tried and tested 12:20:80 Asset Allocation Strategy, it is suggested that an investor keep aside an emergency fund equivalent to their consumption pattern for 12 months.

ET Spotlight

For example, if monthly expenses are Rs 50,000 then an investor needs to maintain emergency fund equivalent to 12 months, i.e., 50,000x12 = Rs. 6,00,000. However, depending on one’s risk appetite, time at hand or income/expenses, he/she can personalize their emergency reserves from a range of 6 months to 36 months of monthly expenses.

Investors can make use of the tried and tested12:20:80 Asset Allocation (Baarah, Bees aur Assi) Calculator on the Quantum website to help them determine how much one needs to set aside for emergency reserves.

ET Spotlight