Liquid funds: Don't focus on returns too much, look at expense ratio

Investors should also look at expense ratio, portfolio quality and track record

Investors, after the defaults in debt funds, are seeking comfort in large liquid funds. Last year, there was only one fund with assets under management (AUM) of more than Rs 50,000 crore. Now, four schemes have crossed that mark. The largest scheme, HDFC Liquid Fund, has AUM of Rs 86,446 crore.

The money is flowing not just because of the size of the funds but also because these schemes belong to fund houses with a track record. “There is a perception that smaller fund houses would chase returns to get more business, which could push them to make risky investments. Larger fund houses, on the contrary, would focus on protecting their credibility and reputation,” says Deepesh Raghaw, an investment advisor registered with the Securities and Exchange Board of India.

Others agree with him. “There have been cases of smaller funds taking concentration risk. Instead of spreading their investments across issuers, they invested a majority of the portfolio in the papers of few companies,” says Malhar Majumder, partner and consultant at Positive Vibes Consulting & Advisory.

A fund with a significant AUM does make sense, but that should not be the only criterion for investment. Larger funds usually have more diversified portfolios. But investors have to also look at other parameters such as the expense ratio, quality of the portfolio, and track record of the fund house. In direct plans of liquid funds, the expense ratio can be as low as 0.07-0.08 per cent and can be 0.20 per cent on the higher side for the majority of the schemes. A higher expense ratio directly eats into the returns of the scheme.

Investment managers say most of the large funds either hold treasury bills or papers of government banks and companies with a sovereign guarantee. “The higher the share of treasury bills or government companies, the safer it would be,” says Raghaw.

Keep the returns the fund is offering as the last parameter when investing in a liquid fund. It’s better to look at funds that are taking the least risk with their investments.

The size of the funds also suggests that it’s institutional money that’s finding its way into these large schemes. Institutional money is usually fluid; that is, companies can withdraw it within a few days of investment. Such events typically happen when companies have to pay advance tax. Can such high withdrawals impact the returns of the portfolio? Investment advisors say that it would not. Fund managers understand this phenomenon and invest accordingly to meet such redemption demand.

Investors also need to remember that no matter how safe the fund manager plays, liquid funds do have default risks or ratings on a security can be downgraded, leading to volatility of returns in the short term. Invest in a debt fund only if you can stomach these risks.