How to Build an Emergency Fund Using Mutual Funds?
While making regular investments is a healthy financial habit, it is prudent to set aside some amount for meeting any financial difficulties. Most of the financial advisors will advise you to hold an emergency fund of around six times your monthly expenses to meet the contingencies of life. At the same time, investing such funds in savings bank accounts may not be a wise idea, for most of the banks offer a measly interest. On the other hand, the prevailing inflation tends to be higher than such interest, thereby effectively letting the balances so kept losing their purchasing power to some extent by just sitting idle. However, you may not also like to invest such surplus funds into traditional investment products, as it may be subject to funds to lock-in period or restrictions on withdrawal, etc. One would not also like to compromise with the liquidity of such contingency fund as well.
Mutual funds tend to offer a better alternative to park such surplus funds in terms of overnight funds and liquid funds. Overnight funds are such debt funds, which invest in overnight securities having a maturity of one day. Similarly, Liquid Funds invest in debt and money market securities with maturity up to 91 days only. Since such funds make investments in securities maturing within a short period, the investors stay highly insulated from interest rate risk as well as credit risk. This stability of returns helps overnight, and liquid funds earn better returns than most of the banks offer on the savings accounts. At the same time, the investors do not have to compromise on the liquidity and the availability of funds.
While overnight funds are named so due to their investment in overnight securities only, liquid funds derive their name due to the liquidity such funds offer to the investors. As compared to the regular equity and debt schemes, liquid funds process redemption requests faster and any redemption transaction received before 3:00 p.m. may help the investors to credit the redemption proceeds in the registered bank account on the next working day. As such, the funds continue to remain liquid and available at short notice for the investors.
When it comes to the returns, the returns generated by mutual funds may not be guaranteed at the time of investment. However, the investors may certainly have a fair idea of the performance of such funds through their historical returns. Overnight funds and Liquid funds have generated an average of 6.04% and 6.92% returns respectively during the last one year (the period from 5th July 2018 to 4th July 2019). Even for the more extended investment period of 5 years, these funds have generated annualized returns of 6.53% and 7.39% respectively (data period from 5th July 2014 to 4th July 2019) (data source – ValueResearchOnline). As such, the past performance of liquid funds and overnight funds has been better than what most of the banks offer on their savings accounts. These returns are even comparable with the prevailing interest rates for short-term fixed deposits, but the investors must commit the funds for a fixed tenor with the banks.
How to build an emergency fund?
Since the investors may now appreciate the benefits of overnight funds and liquid funds in parking the emergency funds, they may start a SIP to contribute to such corpus regularly. As it is said, ‘small drops of water make an ocean,’ steady savings over some time may help you accumulate a healthy emergency fund. Such fund may provide you with a much-needed financial cushion in the face of an emergency.
With the potential of better returns, overnight funds and liquid funds may undoubtedly be the right investment avenue for your surplus and emergency funds without significantly compromising with the liquidity.