What is Liquidity in Mutual Funds?

Nowadays, mutual funds have become a popular investment choice. While mutual funds can offer rewarding returns, it's important for investors to understand certain key terms before diving in. One of these is liquidity. This article will discuss liquidity’s definition and how it impacts your investment decisions.

What is Liquidity’s Meaning?

Liquidity in mutual funds refers to how easily you can buy or sell the mutual fund units. Typically, mutual funds that invest in assets that are easy to trade, such as popular stocks or government bonds, tend to have higher liquidity. On the other hand, if a mutual fund holds securities that are not commonly traded, they have lower liquidity.

For instance, equity mutual funds are generally less liquid than debt funds because equity markets can be more volatile. In contrast, liquid funds offer high liquidity, as they invest in low-risk instruments like commercial paper and have a short maturity period of around 91 days​.

How does Liquidity affect Investment Decisions?

Here's how liquidity affects investment decisions:

1. Risk management

High-liquidity funds are ideal for low-risk investors. They carry less risk because they invest in assets like government securities or large-cap stocks, which are in high demand. This makes it easier to buy or sell these investments without significant price changes.

2. Market conditions

Liquidity can fluctuate with changing market conditions. During economic downturns or market volatility, liquidity may decrease as trading volumes drop, making it harder to sell assets quickly.

3. Investment horizon

For short-term financial goals, liquidity is a key factor in choosing the right fund. Liquid or short-term debt funds are ideal for parking money for a few months. For long-term investors, liquidity is less crucial, allowing them to invest in less liquid funds like equity mutual funds.

4. Emergency situations

In emergencies, like unexpected medical expenses, you can quickly sell mutual funds with high liquidity. These funds allow you to access your money almost immediately. On the other hand, illiquid assets may take longer to sell, and you might not receive the funds when you need them most.

Types of Funds that are more vulnerable to Liquidity Risk

Liquidity risk in mutual funds occurs when you cannot convert your investment into cash. Here are the types of mutual funds that are more vulnerable to liquidity risk-

1. Mutual funds with a higher asset allocation in low quality funds.

2. Close-ended credit risk funds that invest in debt securities with a higher risk default.

Key things to know about Liquidity in Mutual Funds

Here are a few things you should know about liquidity before investing in a mutual fund.

- The higher the liquidity in mutual funds, the lower the risk.

- A mutual fund has less liquidity if it invests in securities that aren't frequently traded, making it harder to sell units quickly.

- When you sell your mutual fund units, the AMC may charge an exit load, which can reduce the fund's liquidity.

- High-liquidity mutual funds are ideal for short-term investments.

Summing up

Mutual fund liquidity gives you more control over your investment. It determines how easily you can sell or buy fund units and access your money when needed.

FAQs

What is the liquidity of funds?

Liquidity of funds refers to how quickly and easily mutual fund units can be converted into cash without significantly affecting their market value, ensuring accessibility to your investments when needed.

Why is liquidity important to a mutual fund?

Liquidity ensures that investors can redeem their mutual fund units promptly, providing flexibility and financial security during emergencies or planned expenses without locking their funds for extended periods.

Do mutual funds have daily liquidity?

Yes, most open-ended mutual funds offer daily liquidity, allowing investors to buy or redeem units at the fund’s net asset value (NAV) on any business day. Close-ended funds do not offer this flexibility.

How to identify liquidity?

To identify liquidity, check the fund type (open-ended funds are highly liquid), the average trading volume of assets in the portfolio, and the lock-in or redemption terms in the fund’s documentation.

What is a good liquidity ratio?

A good liquidity ratio varies by industry, but in mutual funds, a high ratio of liquid assets like cash or marketable securities in the portfolio ensures easier redemption and lower liquidity risk.