Do Liquid Schemes Beat Bank FDs?
MAS Team | 27 February 2014
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If you are planning to stash your money for a little over a year and if you fall in the highest tax bracket, where should you park your money? Fixed deposits (FDs) or liquid schemes of mutual funds (liquid schemes)? Most people would say FDs. After all, banks are safe and everybody keeps money in FDs.

Here is the surprising answer: liquid schemes have proved to be a better option with higher annual returns (post-tax), over the past 10 years. Over a year ago, we had mentioned that liquid schemes may be a better option to park your short-term cash compared with leaving it in savings bank accounts. According to a fresh study conducted by Moneylife, historically, if you held your investment for a little over a year, liquid schemes have not only delivered better post-tax returns compared to bank savings accounts (as shown in our earlier study) but have also done better than the less-liquid bank FDs.

Savings bank accounts and bank FDs are often perceived by investors as the safest option for parking cash. According to the latest Reserve Bank of India data, nearly 50% of household savings is held as bank deposits. Many believe that there is no alternative to bank deposits—of good banks—for parking short-term money. However, liquid schemes have delivered better returns with a reasonably low risk and high liquidity.

Moneylife has done a comprehensive analysis, covering a long period, to avoid any biases. We analysed the annual returns of liquid schemes and bank deposits over each quarter starting with 1 April 2002 and ending 31 December 2012, a period spanning more than 10 years. We took the average return of the top 15 liquid schemes and compared it with the highest fixed deposit rate prevailing for that period. If we analyse the pre-tax returns, out of the 40 annual periods, fixed deposits outperformed liquid schemes in as many as 27 periods.

This does not seem as a good reason to invest in liquid schemes, right? No. Pre-tax returns do not tell the full story. After all, for investors with taxable income, how much return their investment fetches them matters less than how much of that return they actually get to keep. The good part is that one has a fair degree of control over the taxes paid on investment gains. You can choose an investment that is tax-efficient and you can earn better returns.
So let’s look at the tax implications of investing in liquid schemes and bank fixed deposits. If your investment is for less than a year, the short-term capital gains on liquid schemes would be taxed as per your tax slab—meaning that the same tax rate would be applicable for the interest accrued on an FD. However, if the investment is kept for over a year (even one year and one day), the tax rate on capital gains for liquid schemes would be 10% without indexation and 20% with indexation, along with cess. In the case of bank FDs, the interest earned would be taxed according your tax slab which would be a maximum of 30%, plus cess.

Coming back to our analysis, had you been in the highest tax bracket, liquid schemes would have provided better post-tax returns in nearly all the 40 periods. In fact, there were just four periods from 30 December 2008 to 30 September 2010 when liquid schemes underperformed bank FDs. The average post-tax returns over the same period for liquid schemes were 4.78% compared to 5.21% for bank FDs. The average post-tax returns for liquid schemes over the 40 periods were 6.74%, whereas post-tax returns on bank FDs averaged 5.13%.

Even if you were in the 20% tax bracket, liquid schemes would have been a better option in 31 out of the 40 annual periods. But if you are in the lowest tax bracket, liquid schemes would not have given you the added tax advantage; hence, fixed deposits would have been a better option.

Usually, companies and high net worth individuals (HNIs) invest in liquid schemes. Retail investors are still averse to parking their money in such schemes, despite the low costs and better returns they offer compared to a savings account. But they are, indeed, good options. The advantage bank deposits (FDs and savings account) have over liquid schemes is that they are easier to access and offer some degree of principal protection. Liquid schemes boast a higher post-tax yield with higher liquidity compared to bank FDs, if you are in the top two tax brackets and plan to invest for over a year. Further, liquid schemes are not risk-free and an investor must carry out basic checks before investing.