Liquid funds have been around for a long time. The first liquid fund, as per Value Research, was launched in 1997. Today, almost all mutual funds have a liquid fund. Liquid funds have also come a long way in terms of the market risks they can take. I have heard of instances of longer-tenor bonds being part of the liquid fund portfolio in the early 2000s till Sebi, in its steadfast investor protection, introduced maturity restrictions in the portfolios.

Liquid funds were first moved to a regulation where investments had to be made in less than 1-year maturity and instruments which need to be marked-to-market cannot be more than 10% of the portfolio. This markedly reduced the market risks that a liquid fund could take on.

Post the 2008 global financial crisis and with the Reserve Bank of India (RBI) having to offer a liquidity window for mutual funds to meet redemptions, Sebi tightened the norms further by eventually mandating that liquid funds can only invest in instruments which have a maturity of 91 days or less. This took away any ambiguity on the extent of market risks that investors would bear in a liquid fund.

Liquid funds now almost came on par with short-term fixed deposits in terms of its return profile. This greatly benefitted marketing and the positioning of liquid funds over bank deposits. Corporates invested in liquid funds in large measures.

Over the last few years, Sebi has tightened regulations on debt and liquid funds covering various aspects of investment restrictions, concentration limits, funds utilisation, NAV (net asset value) applicability, fair valuation (we do have a differing view, read this), inter-scheme transfers etc. Mutual funds also have to submit a stress testing report to the board of trustees as per a standard definition of stress scenarios of liquidity, market and credit risks. All positive measures for investor protection.

Sebi recently also introduced standardised fund categories by using maturity bands to demarcate debt fund categories. Liquid funds, in the new definition, are funds which have investment in debt and money market securities with maturity of up to 91 days only. This continues the earlier practice of ensuring that liquid funds carry low interest rates risks, but this still does not account for the credit risks that a liquid fund can take.

The investment objective of a liquid fund is to keep your investment safe and liquid and try and achieve slightly higher returns than those from bank savings deposits.

This is how a liquid fund is positioned and marketed to corporates and individuals alike. Liquid funds offer T+1 liquidity, as also insta-redemptions up to 50,000.

Thus, liquid fund portfolios should have very high liquidity, minimum volatility and near-zero chance of capital loss (credit risk or risk of default of interest and principal).

Liquid funds should thus prioritise safety and liquidity over returns. But most liquid funds of today are prioritising returns over safety and liquidity. The recent cases of defaults reported in liquid funds are a fallout of this aspect of chasing returns over safety.

As per data from AceMF, today, an average liquid fund holds around 60% of its assets in instruments issued by the private sector. A good share of that is invested in private corporates which are not AAA rated. About a third of the assets are invested in instruments issued by non-banking finance companies or NBFCs. The liquidity and the credit quality of these instruments may not be commensurate to the liquidity and safety objectives of a liquid fund. This is not what the investor signed up for. This is not the objective of a liquid fund.

Retail investors invest their short-term cash surplus in liquid funds to earn more than what they do from a savings account. Corporates invest in liquid funds to earn anything more than the zero interest in their current accounts. Financial planners advise equity investors to park their lump sum money into liquid funds so as to be able to switch/transfer their allocations to the equity fund at regular intervals. Equity mutual funds, PMS managers park their cash holdings in liquid funds waiting for an opportune time to buy equities. Most of them are not aware and/or are not prepared to see a capital loss in their liquid fund investments.

Today, thousands of new investors are investing in mutual funds, tomorrow it would be millions. The liquid fund, with its positioning of safe and liquid, becomes a natural allocation for all investors. The liquid fund, though, in its current nature is not being true to its label and the mutual fund industry risks leaving a lot many investors with dissonance.

Investors deserve liquid funds which do not take credit risks. Sebi should mandate that liquid funds be allowed to invest only in government securities, treasury bills and AAA rated instruments issued by public sector undertakings (PSUs). This will truly make liquid funds as they should be—safe and liquid.

Arvind Chari, is head – fixed income and alternatives at Quantum Advisors Pvt Ltd.