Liquidity in mutual fund: Converting investment into cash

Imagine you have invested in a mutual fund and you suddenly need cash for a medical emergency or an unexpected expense. How quickly can you sell your investment and get access to funds without losing too much value? That is where liquidity comes in.

Liquidity in mutual funds indicates how easily you can convert your investment into cash without impacting your investment value. It’s a key factor in deciding which funds to invest in, managing financial risks and ensuring you have access to your money when you need it.

In this article, we will explore what liquidity means, why it matters in mutual funds, and how it shapes investment strategies.

• Table of contents

1. Understanding liquidity
2. Understanding liquidity in mutual funds
3. Influence of liquidity on investment decisions
4. How do AMCs ensure liquidity?
5. Types of funds with higher liquidity risk
6. Different types of liquidity
7. Five things to know about liquidity in mutual funds
8. Role of liquidity in investments

Understanding liquidity

Liquidity is how easily you can turn an asset into cash without losing much value. Some assets, like cash, can be used immediately, while others, like property or fixed deposits, take time to sell. Highly liquid assets can be quickly bought or sold without affecting their price. On the other hand, illiquid assets may take longer to sell and could lose value in the process.

For example, cash is the most liquid asset because you can use it anytime. But real estate or long-term deposits are less liquid because they take time to sell or withdraw and early exit in the case of long-term deposits can incur a penalty. Liquidity is important for investors who need easy access to money.

Understanding liquidity in mutual funds

Liquidity in mutual funds refers to the ease and speed with which investors can buy or sell units of a mutual fund without affecting its net asset value (NAV). Mutual funds provide varying levels of liquidity based on the type of fund and the underlying assets in the portfolio.

For instance:

• Open-ended funds offer high liquidity as investors can redeem their units at any time.
• Close-ended funds have limited liquidity, as they can only be redeemed upon maturity. In the interim they can be traded on stock exchanges, and liquidity will depend upon demand and market value.
• Close-ended funds have limited liquidity, as they can only be redeemed upon maturity. In the interim they can be traded on stock exchanges, and liquidity will depend upon demand and market value.
• Typically, liquidity is higher in debt mutual funds because they are relatively stable in the short term. For equity funds, even if the money is accessible, the NAV can vary significantly depending upon market conditions, so you may sell at a loss.
• Some asset management companies offer instant redemption for select schemes (such as liquid funds or overnight funds), enhancing liquidity.

Influence of liquidity on investment decisions

Emergency fund access

Investors who need quick access to funds may find highly liquid mutual funds like liquid or overnight debt funds more suitable.

Market conditions

During market volatility, investors may seek to exit certain funds. Highly liquid funds provide the flexibility to do so without incurring heavy losses.

Portfolio allocation

Investors balance their portfolios based on liquidity needs. Investors may seek a combination between low-risk funds with high liquidity, high-risk funds with better long-term return potential and stable avenues such as bank deposits that have limited liquidity but offer capital protection and predictable returns.

Redemption flexibility

Mutual funds with high liquidity allow investors to withdraw their money easily without waiting for long periods.

Risk management

Investors often choose liquid funds to manage risk and hedge against unforeseen financial emergencies.

How do AMCs ensure liquidity?

For open-ended funds, AMCs ensure liquidity by maintaining cash reserves, diversifying assets, and complying with SEBI’s liquidity rules. They offer daily NAV-based redemptions in open-ended funds and may be required to conduct stress tests to manage risks. These strategies help meet investor withdrawals smoothly while maintaining fund stability.

Types of funds with higher liquidity risk

Liquidity risk in mutual funds arises when investors struggle to convert their investments into cash without significant loss. Some mutual funds are more exposed to this risk, such as those investing in lower-quality assets that may be harder to sell quickly.

Additionally, close-ended funds face greater liquidity challenges as they can only be traded on the stock exchange before maturity.

Read Also: Liquidity in Shares vs Mutual Funds: A Complete Guide

Different types of liquidity

• Market liquidity: The ability to buy or sell assets in the market without affecting their price significantly.
• Funding liquidity: The ease with which investors or institutions can meet their cash flow obligations.
• Asset liquidity: How quickly a particular asset can be converted into cash without losing value.
• Operational liquidity: The ability of fund managers to manage redemptions effectively without disrupting fund performance.

Five things to know about liquidity in mutual funds

• Open-ended funds are more liquid than close-ended funds.
• Liquidity risk rises in market downturns, leading to lower asset prices.
• When you sell your mutual fund units before a certain minimum holding period, the AMC may charge an exit load, which can reduce the fund's liquidity. This is not applicable to all schemes and reading the scheme information document is essential to find out if your fund levies an exit load.

Role of liquidity in investments

• Providing financial flexibility: Liquid investments allow investors to access funds in emergencies.
• Enabling portfolio rebalancing: Investors can easily switch between funds to align with market conditions.
• Reducing uncertainty: High liquidity reduces the risk of being stuck in an investment.
• Enhancing market efficiency: Liquid markets help in fair price discovery and efficient trading.
• Affecting investment horizon: Investors with short-term goals prefer liquid funds, whereas long-term investors may opt for less liquid avenues that offer better return potential over time.

Read Also: Understanding NAV and Returns in Liquid Mutual Funds

Conclusion

Liquidity in mutual funds is an important factor driving investment decisions, risk management, and financial planning. While open-ended funds allow investors to redeem funds at any time, it can result in a loss if market conditions are unfavourable, especially with equity funds. So, low-duration debt funds such as liquid or overnight funds can be more suitable for investors looking for easy access to cash in the short term.

Meanwhile, funds with a lock-in period do not offer liquidity for a specified period and close-ended funds can only be sold and traded on stock exchanges before maturity, which can limit liquidity. Investors should assess their liquidity needs before selecting a mutual fund to ensure they can access their money when required. By understanding liquidity and its role in investments, investors can make informed decisions and optimise their portfolios for both relative stability and return potential.

FAQs:

What is the liquidity of funds?

The liquidity of funds refers to how quickly and easily investors can buy or sell mutual fund units without significantly impacting their value. Higher liquidity means faster access to cash, while lower liquidity may result in delays or losses when redeeming investments, especially during market fluctuations or economic downturns.

Why is liquidity important to a mutual fund?

Liquidity is important for mutual funds as it enables smooth redemptions, reduces risk, and allows investors access their money when required. It allows fund managers to handle withdrawals efficiently without significantly impacting the portfolio and the investment strategy.

Do mutual funds have daily liquidity?

Most open-ended mutual funds allow investors to place redemption requests based on the applicable day-end NAV. However, standard redemption timelines apply, meaning that it may take a few business days for the money to reach your account. Some AMCs may offer instant redemption for select schemes.

How to identify liquidity?

Liquidity can be identified by checking factors such as fund type, asset holdings, trading volume, and AMC policies.

What is a good liquidity ratio?

A good liquidity ratio varies by investment type and market outlook, but for mutual funds, maintaining sufficient cash reserves and holding highly tradable assets ensure better liquidity.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.