The Covid-19 pandemic taught many personal financial management lessons to individuals, one of the most important being the value of an emergency fund to deal with a crisis. An emergency fund can come to the aid when there is a financial crunch arising out of situations like job loss, health expenses, unforeseen drop in household income, etc.
While one must have an emergency fund to deal with financial hardships, it is equally important to focus on where this fund or money is parked. Should we keep it in our bank savings account or invest in equity instruments or mutual funds?
There are many investment options where one can park an emergency fund to ensure that the funds are easily available when needed. Most people opt for liquid funds to set aside their emergency corpus.
Here, we will begin by discussing the need for an emergency fund, parking emergency corpus in liquid funds, and lastly, talk about some other avenues that investors can consider for setting aside such funds.
Need for an emergency fund
An emergency fund provides the much-needed financial cover without significant delay. Although one may get a few hours to a few days in dealing with most emergencies, many times, it may require instant fund availability. Therefore, an emergency corpus should always be easily accessible whenever needed and should be maintained in cash or cash-like form. If an entire or a part of the emergency corpus is invested in avenues like liquid mutual funds, one can be assured of a lower risk of capital loss and stable returns. There are also many other avenues that can be used to set aside the emergency corpus.
What are liquid funds?
Liquid funds are a type of debt mutual funds that invest in short-term money market instruments carrying a maturity of a maximum of 90 days. Some of the instruments that these funds invest in include Commercial Papers, Term Deposits, Certificate of Deposits (CDs), Treasury Bills, etc.
Point to note – Liquid Funds offer high liquidity and very low risk.
How do they work?
Just as an investor deposits his/her money in a bank account, they can invest in liquid mutual funds that further allocated the pooled money across the avenues mentioned above. These funds focus on investments in short-term debt instruments with maturities of under 13 months. The average maturity period of instruments considered by such funds is less than 90 days. By maintaining a short investment time frame, these funds ensure minimal risk exposure.
Point to note – While liquid funds fall under lowest-volatility investments, they are not entirely risk-free.
Investing emergency corpus in liquid funds
Many investment experts would advise parking a certain portion of an emergency fund in liquid mutual funds. This is because of the following reasons:
- These are relatively safe vis-à-vis other mutual funds.
- They tend to deliver higher returns as compared to a savings bank account.
- These are highly liquid since they invest in instruments with lower maturity periods.
Some of the benefits of parking emergency corpus in liquid funds are:
- Withdrawing an emergency corpus from liquid fund investment is easy. One can redeem the investment within the stipulated cut-off time by placing a request on the mutual fund website. Once the fund house verifies the request, the money can be credited to the registered bank account of the account holder on the same business day.
- Many mutual funds provide ATM facilities to allow investors to withdraw from their liquid fund investments.
- It is one of the most easily accessible investment avenues.
Points to consider
Although they are considered liquid, an investor should know that even an online withdrawal from the fund may take about 1-3 days for the credit to reflect in one’s bank account. Many mutual funds allow ATM withdrawal from such schemes of up to Rs. 50,000 per day.
Bank FDs come with deposit insurance of Rs. 5 lakhs. However, there is no such protection offered in liquid funds.
Other options for parking emergency funds
For those who are looking for alternatives to liquid funds for setting aside their emergency corpus, here are some options to consider:
- Bank deposits
With bank fixed deposits, one can earn a safe interest rate of around 4-6%, depending on the tenure. Premature withdrawals may come with a penalty, however, this is an almost risk-free investment for emergency funds.
- Gold ETFs
Gold ETFs are also a good option for parking aside emergency funds. These can be bought/sold just like stocks on exchanges. Therefore, investors can enjoy better liquidity, safer returns, and the safety net offered by real gold held with the gold custodian.
- Other debt funds
Some of the other debt fund alternatives to consider for emergency fund investment are ultra-short duration funds, short-duration funds, and overnight funds. These offer higher liquidity, predictable returns, and considerable safety of invested capital.
Emergencies and consecutive financial burdens are often difficult to anticipate. However, many people have recently gone through various emergencies like job loss, death of an earning family member, pay cuts, medical emergencies, etc due to the Covid-19 pandemic. Therefore, having an emergency fund has become an important financial goal for most individuals. Investors can consider parking some portion of their emergency corpus in liquid funds to ensure liquidity and low risk of capital loss.
Since liquid funds are a type of debt investment and short-term, capital gains from these are taxable at 20% without indexation benefit.
Investors with a low-risk appetite and short-term goals can invest in liquid funds. Also, those who want to set aside some funds for emergencies can park some money in these. These can also be used for portfolio diversification.
During rising interest rates, there is a short-term liquidity crunch as monetary policy is tightened. However, the performance of liquid funds tends to remain unaffected. Therefore, these can be a good investment option to park the surplus corpus for short-term and higher liquidity.
Bank FDs offer low returns and low liquidity as compared to liquid funds. However, liquid funds may carry some amount of risk, whereas bank FDs are practically risk-free.