A risk is a calculated uncertainty that every asset possesses. Liquidity risk is one such uncertainty introduced by the securities market for investment. When an investor acquires an asset, they expect that the investment will mature (as with a bond) or that it will be salable to someone else. In any of these cases, the investor expects to be able to convert the security into cash and use the proceeds for current consumption or other investments. The more difficult it is to make this conversion to cash, the greater the liquidity risk.
What is liquidity for investing context?
In case of emergency, one needs assets that can be converted to cash quickly without significantly affecting the asset’s price. An asset is said to be liquid if it can be quickly converted to cash at a price close to the fair market value. Among the different asset class cash is the most liquid. Apart from it, there are stocks which fall in the category of a liquid asset because the investors can sell them conveniently. In contrast, examples of illiquid investments include a work of art, an antique, or a real estate.
How liquidity in mutual funds is beneficial?
Mutual funds are market-linked products the liquidity of which is beneficial in a number of ways.
In case of underperformance by a fund or group of funds the benchmark across time intervals, one may use their liquidity option to either redeem that particular fund or switch to a better fund.
There is a time gap between investing in a fund and the due date of the fund. During this time gap, the market can be volatile due to various economic scenarios. An investor can review the liquidity offered by the funds keeping in mind the dynamic changes in the economy. Based on such analysis one can rebalance or restructure their portfolio according to their risk appetite.
In order to optimize the market volatility, investors need to make exit at an appropriate time in order to fulfill long term goals such as retirement planning. Mutual funds offer facilities such as Systematic Transfer Plan (STP) and Systematic Withdrawal Plan (SWP) for this purpose. STP funds will help you transfer your risk from a high-risk equity fund to low-risk debt funds as an investor nears retirement. SWPs help to redeem fund in a proper manner.
Investors sometimes come across emergencies that demand sudden requirement of cash. Mutual funds being liquid in nature an investor can create a highly liquid emergency fund known as Liquid Fund. These are debt funds that give a higher return in comparison to a regular savings account in a bank. This type of fund offers flexibility to withdraw money for emergency needs at any given point without incurring an exit load.
Liquidity being an important parameter one should make decisions as per their personal goals and as per ones risk taking capacity.
What is a Mutual Fund Liquidity Ratio?
Liquidity ratio is a numeric representation of its cash position. A mutual fund liquidity ratio is a ratio which compares the amount of cash in a fund relative to its total assets in the fund. Mutual fund liquidity ratio varies and includes cash or all cash and cash equivalents. Cash-equivalent assets include government bonds with less than one year to maturity, certificates of deposit and others that can be turned into cash at practically any time with no loss in value. In essence, these assets represent the money held by the fund that is not invested in risky assets such as stocks and corporate bonds.
Mutual funds report the mutual fund liquidity ratio to investors in order to provide them with insights on how much cash the fund is holding. The ratio is a simple percentage dividing either the total cash or the total cash and cash equivalents by the fund’s total assets.
Mutual Fund Liquidity ratio = (Total Cash or Cash and Cash equivalent/Funds total assets) x 100
Mutual fund cash levels act as an indicator of industry speculators in order to understand the market’s direction. Most funds keep approximately 3% to 5% of their total assets in cash.
What Is The Importance Of Mutual Fund Cash-To-Asset Ratios?
A mutual fund cash-to-asset ratio is an important factor in determining the extent of liquidity that a mutual fund possesses. In most of the cases, mutual funds stock up on huge amounts of liquid cash whenever a sizeable purchase of securities is nearing. High cash-to-asset ratios are considered to be bullish in nature, whereas low cash-to-asset ratios tend to be more bearish in nature.
The importance of cash-to-asset ratios can be better outlined in the following ways:
• Cash-to-asset ratios help the fund managers make the right choices about which stocks to invest in and what is the right time to do so.
• Cash-to-asset ratios also help fund managers to see the market condition and are there a case for improvement and also get alert in
downfalls.
• Cash-to-asset ratios are an effective tool for the fund manager for managing an investor’s portfolio.
What Do Low Cash-To-Asset-Ratios Indicate?
In case of Mutual funds with low cash-to-asset ratio indicates that the fund has opted to park its assets in bonds, annuities and other investment options that come with a low level of risk. Funds with such characteristics are considered to be bullish and managers see an improvement in the near future.
What Do High Cash-To-Asset Ratios Indicate?
A high cash-to-asset ratio indicates that a mutual fund holds a huge amount of liquid cash, i.e.: it has a, it is generally viewed as being bearish in nature, due to volatile market conditions or the fund is finding it difficult to zero-in on investment options or opportunities it considers to be of any quality.
If you want to create an emergency fund, then liquid funds can prove to be very useful. In addition to receiving higher returns, these will help you to take out your money easily in case of emergencies. Mutual funds are subject to market risks and hence investors must keep in mind their objective and goal before investing.
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