Understanding the asset allocation of a liquid fund

As a smart investor, investing in funds that match your risk profile, investment objectives, and time horizon is always important. But every investor has their own unique set of goals, risk tolerance, and expectations. Some prefer high-risk, high-reward investments, while others opt for steady and consistent returns. And for those looking for stability, liquidity, and low-risk options, liquid funds can be a worthwhile addition to their portfolio. 

A liquid fund is an open ended mutual fund that invests primarily in debt securities and money market instruments such as treasury bills, certificates of deposit, and commercial paper with short maturity periods (typically up to 91 days). Due to their asset allocation in short-term securities with low volatility and minimal risk, liquid funds can be ideal for emergency funds or short-term financial goals.

The asset allocation of liquid funds is based on several factors, including the creditworthiness of the issuer, the liquidity of the instruments, the interest rate risk involved, and the fund manager’s investment philosophy. Given its importance, let’s understand the asset allocation strategy of liquid funds in detail and why it is crucial for your investment decisions.

1. Investment objective of liquid funds governs the asset allocation

Most funds have an investment objective and guidelines set out by the AMC, which they use to determine the asset allocation within their funds. Depending on the type of fund you choose, different proportions may be assigned to each security type.

To provide high liquidity and reasonable returns with low risk to the investors, these types of mutual funds invest in instruments that have high liquidity and low credit risk. This helps the fund maintain a stable net asset value (NAV), helping investors confidently evaluate the associated returns.

2. Types of instruments

When it comes to asset allocation in a liquid fund, the fund manager has a wide range of instruments to choose from. These include treasury bills, commercial papers, certificates of deposit, and collateralized lending & borrowing obligations (CBLO). The fund manager’s role is to identify the best instruments that offer high liquidity, safety, and profitability within the regulatory guidelines.

3. Risk management

Asset allocation inliquid mutual funds is not just about profitability but also risk management. The fund manager has to ensure that the portfolio is well-diversified to reduce risk. This means that the fund must not have concentrated exposure to a single issuer, sector, or instrument. Additionally, the fund manager has to monitor the credit ratings and interest rates to ensure that the portfolio is not exposed to credit and interest rate risks.

4. Interest rate sensitivity

Interest rate and credit risk are major concerns for all debt funds types, including liquid funds. These mutual fund schemes invest in securities with short maturities, which means that their performance is closely linked to the prevailing interest rates. Lower interest rates can lead to lower returns, while higher interest rates lead to higher returns. Given this, the fund manager needs to be vigilant and allocate assets according to the interest rate scenario.

To wrap up

Understanding the asset allocation of a liquid fund is crucial as it allows investors to evaluate the risk profile of the fund and to determine if it aligns with their investment goals. With liquid funds, you, as an investor, can reap the benefits of reduced risk, instant redemption, the ability to park surplus funds, and steady short-term income.

Also, the availability of digital platforms and investment apps makes it easier than ever toinvest in liquid funds with minimum documentation. To further enhance the returns on your investment, it’s always wise to seek advice from a financial advisor and develop a well-thought-out strategy.

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