Liquid funds first started to bleed in October 2008. Actually, it wasn?t even a small cut, it was a gaping wound. And now, almost a year later, liquid funds seem to be dying a slow death. This fact is apparent from the minuscule returns that these funds have generated in the past couple of quarters.
Essentially, liquid funds are meant for investors who want to park their idle cash somewhere for short periods of time, which could be a couple of days or a few weeks. What attracted such investors towards liquid funds was that they generated higher returns than bank deposits, and via supposedly risk-free portfolios. To do this, fund managers had to invest in debt instruments with extremely short residual maturity, simply because such instruments react little to interest rate changes. Such instruments ideally had maturities of not more than two to three months. But since there was no rule governing this aspect, fund managers started to opt for instruments with longer maturity to generate higher returns which of course came at higher risks. With fund managers drifting towards longer maturities, liquid funds started to sport average maturities of almost 11 to 12 months.
And then the crisis hit. Many funds had stretched their maturity beyond the safe limits and hence, lost money. Under severe redemption pressures, they had to be bailed out by Asset Management Companies (AMCs) and parent companies. This credit crisis forced Securities Exchange Board of India (Sebi) to reevaluate the laws governing liquid funds. In January 2009, Sebi released the new laws under which liquid funds were asked to shorten their maximum maturity to six months by February 1, and further to three months by May 1.
The new law fully kicked in on May 1, and since then, the impact is apparent, and the news is not good. In 2007, the average annual returns of liquid funds were 7.76% . In 2008, they were 8.76% . During these years, in most quarters, returns varied from 1.6% to a high of 2.2% .
But now, these numbers have dwindled drastically and come down to 1.1% and 1.3% for the past two quarters. 1.1% a quarter corresponds to about 4.5% per annum. This is in the same region as bank term deposits returns. Even State Bank offers three per cent for deposits of up to 45 days and four per cent for up to 90 days. These time periods compete with liquid funds and the returns are quite lucrative.
What worked in favour of funds ? over banks ? was a tax arbitrage. But when the new direct tax code comes in, this tax arbitrage will be gone as well. Further, after last October?s experience, banks? higher level of security will turn out to be a major advantage. For the short periods of these investments, the absolute difference is extremely small. For a deposit of Rs 1 crore, a liquid fund will earn an extra Rs 20,000 over bank deposits over 45 days. Even with the difference in taxation, this doesn?t sound exciting.
Today, liquid funds manage almost 20% ? Rs 1.34 lakh crore of the total Rs 6.9 lakh crore ? of the assets managed by the entire mutual fund industry. This number is quite significant pertaining to one particular class of fund. But with the new regulations forcing returns to go south, it?s hard to imagine that liquid funds will continue holding such a prominent share of the industry?s assets under management in the coming times..
?Author is the CEO of Value Research
