Comparing Liquid Funds and Liquid ETFs: Which is Better? (2024)

Liquid funds invest in short-duration papers such as government securities, T-Bills, commercial paper, call money, etc. They are an ideal instrument for parking excess money which you might need at a short notice in the future. The risk associated with them is low as they primarily invest in papers that mature within a few days, and in companies that have the highest credit rating(such as AAA), so the chances of default are low in liquid funds.

Broadly, there are two ways to invest in these funds. One, you select a scheme and invest directly using the fund house’s website or apps like ET Money. The other is by purchasing liquid ETFs through a stock exchange, using your trading account. But which is better – liquid funds Or liquid ETFs? To answer this let’s first look at each of them.

Investing In Liquid Funds

• Liquid Fund primarily invests in debt securities maturing within 91 days. And they are managed just like any other debt scheme – the options they offer (Growth, IDCW), and how the money is invested is similar to how other debt funds work.
• You can invest in them through your distributor, or through apps such as ET Money. Whenever you want to redeem the money you can approach your fund house, or the distributor or do it yourself.
• Since they invest in highly rated papers(AAA) with low duration, they have low volatility and low risk. Hence, you don’t need a long-term horizon when investing in them.
• Here you can invest any amount of money, and can even redeem fractional units you get when your returns are reinvested (in case of growth option).

Investing In Liquid ETFs

• Liquid ETFs are another liquid instrument that invests in overnight securities, But you need a Demat account to invest in these ETFs. They trade on the stock exchange just like stocks. Currently, there are 3 liquid ETFs – Nippon Ind ETF liquid Bees, DSP Liquid ETF, and ICICI Prudential S&P BSE Liquid Rate ETF
• One unique factor about these ETFs is that their trading price is always Rs. 1,000. Whatever returns you get are distributed in the form of a dividend.
• However, you don’t get these dividends in your bank account. Rather they are reinvested in the ETFs itself. So, you get fractional units of the ETF, equivalent to your post-tax dividend amount.
  Say you invested Rs 1,00,000 in them and earned 0.5% during your holding period. This translates to Rs 500. After-tax, you may get a minimum of Rs 350. In most of the ETFs, they will allocate you a fractional unit of ETFs worth Rs 350. The disadvantage here is that you cannot redeem fractional units of the ETFs. The ETF worth Rs.350 will be in your account and you will be able to sell it only when it becomes a whole unit worth Rs.1,000.

After reading about both the liquid instruments they must look quite similar. Liquid ETFs clearly have a disadvantage – not being able to redeem fractional units. But let’s not arrive at a decision already and dive a little deeper. Let’s compare these two instruments on the basis of the returns they have to offer.

Comparison Of Returns By Liquid ETFs And Liquid Funds

Liquid ETFs invest primarily in overnight securities so they are less risky than liquid funds that invest in securities with a maturity up to 91 days.

However, this also translates into lower returns on ETFs. This is visible in the table below.
Liquid funds have higher returns than liquid ETFs.

Returns as on 12 Jan 2023

Further, the returns for liquid ETFs get even lower if we consider transaction costs and taxes. Transaction costs can be approximately 0.2% or higher with non-discount brokers. And in liquid ETFs, the returns are necessarily distributed as dividends, which are taxed as per your income slab. For Liquid funds, you have the option to choose a growth plan where the returns are not taxed unless you redeem them. So, returns are lower for liquid ETFs when compared to liquid funds.

One of the factors contributing to lower returns for ETFs could be their high expense ratio. Typically ETFs have a lower expense ratio, however here it’s the other way around. The table below shows that ETFs have a higher expense ratio than liquid funds.

One of the factors behind a higher expense ratio is the infrastructure needed for daily dividend options.

So after reading the above, you might wonder why anyone would invest in liquid ETFs. They have the following disadvantages.

• You can’t redeem fractional units until they become whole units of ETFs.
• And they even have lower returns in comparison with liquid funds.

However, there is one advantage that can make you invest in Liquid ETFs over liquid funds. Let’s look at it.

Advantages Of Liquid ETFs

If you are a trader or a direct equity investor then you might be keeping some idle cash in the fund account with your broker. You keep that balance because you are waiting for an opportunity and don’t want the hassle to withdraw and add funds again. But until you find the next opportunity, you are not earning any returns on them. However, you can earn returns if you invest in liquid ETFs.

You can buy liquid ETFs with the amount lying idle in your broking/trading account and earn a return on it. As and when you find your opportunity you can liquidate these ETFs holdings and deploy the capital in your desired stock.

If you’re a trader then there is another advantage. When you trade in derivatives you need margin money in your account. And these ETFs holdings can be pledged to get margin money.

After a haircut of 10%, you can use up to 90% of your liquid ETF’s value as margin money. And most importantly you will keep earning returns even on the 90% of the liquid ETFs that you have pledged. The margin provided on the pledged units of liquid ETFs can differ from broker to broker.

So, even though liquid ETFs offer less returns, active stock investors and traders can use this to get some returns than no returns on the amount in their trading account..

Now let’s go back to our starting point – Which is better liquid fund or Liquid ETFs

Which Is Better – Liquid Funds Or Liquid ETFs?

By now you might already know the answer. But to summarize – if you are an active stock investor or a trader then you can explore liquid ETFs. They can be an ideal option for you as you can earn returns on the amount lying idle in your broker/trading account. Further, you can even pledge those holdings and get a margin for trading.

However, if you don’t have a Demat account or don’t do trading then liquid funds are a better option for you. They have lower transaction costs, offer comparatively higher returns, and even have convenience to sell fractional units.