Imagine you have some surplus money and are wondering where to park it for a short duration? If you believe savings accounts, fixed deposits, and liquid funds are the only options, then wait. As capital markets continue evolve in this digital era, new investment avenues have emerged that combine the features of traditional instruments with market-linked flexibility. One such recent option to invest money in India for a short period is a liquid exchange-traded fund or liquid ETF.
In this article, we will explore what a liquid ETF is, how it operates, its potential benefits, taxation aspects and who may consider investing in it.
What Are Liquid ETFs?
Liquid ETFs are mutual funds whose units are listed and traded on stock exchanges, just like shares. These funds typically invest in low-risk, short-term instruments such as triparty repo (TREPS), repo, reverse repo and other permitted cash-equivalent instruments. Their short maturity profile generally results in relatively low interest rate risk.
The primary objective of liquid ETFs is to generate returns that are aligned with short-term money market rates while seeking to provide high liquidity. By allocating idle funds into liquid ETFs, investors may seek to earn returns on surplus funds while maintaining liquidity, subject to market conditions and scheme-related risks.
Benefits of Investing in Liquid ETFs
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Activating Idle Capital
Liquid ETFs can help investors put surplus money to work instead of allowing it to remain unused in a savings or trading account. Investors can park their excess cash in these funds and potentially earn returns while keeping the money relatively accessible for future needs or transactions.
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Useful as Trading Collateral
Liquid ETF units may also be accepted by stockbrokers as collateral for meeting trading margin requirements, subject to applicable rules and broker policies. This can allow investors to make productive use of their available funds instead of keeping the entire margin amount idle.
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Cost-Effective Fund Management
Since Liquid ETFs are generally passively managed, they usually involve relatively lower fund management costs compared with actively managed investment options. However, investors should consider brokerage and the bid-ask spread when trading on the exchange.
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Low Interest-Rate Sensitivity
Liquid ETFs primarily invest in overnight or very short-maturity instruments and may have lower interest-rate sensitivity than longer-duration debt funds.
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Simple Buying and Selling
Investors with a demat and trading account can buy and sell liquid ETF units through the stock exchange, much like other exchange-traded investments. This makes it relatively convenient to move surplus funds between investments and trading activities.
Who Can Invest in Liquid Exchange-traded Funds?
Short-Term Investors: Investors looking to park surplus funds for a short period while waiting for a suitable investment opportunity may consider Liquid ETFs because of their relative stability and high liquidity.
Investors with a Low Risk Appetite: Those who prioritise preservation of capital and relatively low interest rate risk may consider liquid ETFs. However, it must be remembered that these instruments do not offer guaranteed returns or capital protection.
Investors Comfortable With Demat Investing: Since liquid ETFs trade on an exchange, they may be suitable for investors who already maintain a demat and trading account.
Taxation on Liquid ETFs
Liquid ETFs that invest more than 65% of their assets in debt and money-market instruments are treated as Specified Mutual Funds under Section 50AA of the Income-tax Act.
Under the current rules, capital gains arising from sale of these fund units are taxed as follows:
Units acquired on or after April 1, 2023: Capital gains are deemed to be short-term capital gains regardless of the holding period. They are taxed at the investor's applicable income-tax rate.
Dividend taxation: Any dividends distributed by liquid ETFs are taxable in the hands of the unit holders at their respective applicable income-tax slab rates. Mutual fund companies may deduct 10% TDS for resident individuals if total dividend payouts exceed ₹10,000 in a financial year.
Things to Consider Before Investing in Liquid ETFs
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Fractional Units
Returns from Liquid ETFs may be credited as additional units, including fractional units. These fractions typically cannot be traded on the exchange but are generally bought back by the mutual fund house. In some schemes, income accrues in the NAV, while certain IDCW structures may distribute or reinvest income.
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Brokerage Charges
Investors may incur brokerage charges when buying or selling Liquid ETFs, depending on their broker. Since charges vary, investors should check the applicable brokerage before investing.
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Liquidity and Price
Although liquid ETFs are designed to offer high liquidity, units may trade at prices slightly above or below their indicative NAV depending on demand, supply and the bid-ask spread. Investors must check both the iNAV and market price before placing an order.
Conclusion
A liquid ETF is a modern investment option that combines the features of short-term debt instruments with the flexibility of stock market trading. It provides a way to manage surplus funds while maintaining liquidity and transparency. However, investors should consider taxation, trading costs, bid-ask spreads and scheme-specific features before investing.
FAQs
How does a liquid ETF work?
A liquid ETF invests in overnight, low-risk instruments such as tri-party repo, which generate a small amount of interest each day. This daily income is typically reflected in the ETF’s iNAV (indicative Net Asset Value) although some plans may use scheme-specific IDCW or reinvestment mechanisms. Investors can buy or sell Liquid ETF units through the stock exchange using their demat account, just like shares. Typically, transactions are settled on a T+1 basis, meaning the units or funds are credited on the next business day.
What is the minimum investment amount for liquid ETFs?
The minimum investment depends on the price of one unit of the ETF on the stock exchange. Since ETFs are traded like shares, investors can buy even a single unit, subject to the prevailing market price and brokerage requirements.
How does a liquid ETF differ from a traditional liquid fund?
A liquid ETF is traded on stock exchanges and requires a demat and trading account, and can be bought or sold during market hours. Its market price may fluctuate around its iNAV (indicative Net Asset Value). On the other hand, a traditional liquid mutual fund is purchased or redeemed directly through the AMC or an intermediary, does not require a demat or trading account, with transactions based on the applicable end-of-day NAV.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.