How equity investors can optimise returns using liquid ETFs

Since the pandemic-induced correction, there has been a spurt in retail investor participation in equity markets. Even as geopolitical tensions and liquidity tightening measures continue to roil both domestic and global markets, domestic investors, including retail, domestic institutional investors, and HNIs, continue to be the driving force behind the Indian markets, with their combined share in companies listed on the National Stock Exchange (NSE) reaching an all-time high of 23.34% as of March 31, 2022.

In fact, retail investors own 7.42 per cent of companies listed on the NSE, a figure that is almost on par with domestic mutual funds that together hold 7.75 per cent of the same listed space. Despite this newfound hegemony, the bulk of retail investors still relies on parking their trading capital in a savings bank account or with their brokers, thereby losing out on generating additional income using other opportunities available today.

For both direct equity investors and derivatives traders, it is a common practice to book profits consistently and keep the received capital in a savings bank account at marginal interest rates or hold it in the broker’s margin account, which does not offer any returns.

To make matters worse, the funds generated by selling equities are available only on T+2 days, where T is the date on which the trade has been made, further compounding the liquidity crisis every trader faces.

Additionally, when involved in futures and options trading, investors may need to raise margin money by transferring the requisite capital into their margin account, a time-consuming affair that could rob them of trading opportunities in volatile markets.

Offering a solution to these unique problems, it is far more logical for retail investors to invest sale proceeds in a liquid exchange-traded fund (ETF) and enjoy the additional benefit of earning returns on such trading capital without assuming much risk. To recapitulate, liquid ETFs can provide reasonable returns with low risk and high levels of liquidity.

A type of passively managed debt mutual fund, liquid ETFs are listed and traded in the cash segment of the NSE as well as the BSE, offering investors the opportunity to buy and sell their units during trading market hours.

A liquid ETF predominantly invests in Tri-party Repo (TREPS), which facilitates the borrowing and lending of funds in a Triparty Repo arrangement. With Sebi norms mandating that liquid funds only invest in debt and money market securities with maturities of up to 91 days, returns generated from liquid ETFs are relatively more stable since such short-term debt securities are less prone to price fluctuations than those with a long-term holding period.

Liquid ETFs also offer a daily income distribution cum capital withdrawal (IDCW) plan. Here, there are multiple approaches to dividend distribution. Some fund houses reinvest the dividend, and the additional fractional units that are generated can be sold through brokers or held for the long term. The other approach followed by

, with regards to Liquid ETF, is that the dividend accrued is credited to the investor’s bank account.

For retail investors, therefore, it is prudent to purchase units of a Liquid ETF at the time of selling equity shares by way of instructing the broker to invest the equivalent amount. When wanting to purchase some equity shares, one can ask the broker to make the purchase using the same Liquid ETFs as Liquid ETFs can be used as margin money. Most stockbrokers in India allow 100% of the sale proceeds from a share sale to be invested in a Liquid ETF on the same day. These ETF units can also be used as a cash-equivalent margin in Futures & Options (F&O) trades as well, negating the requirement to remit additional funds to your broker’s account. Thus, not only do Liquid ETFs generate returns right from the date of settlement till the date of liquidation, but they also allow retail investors to benefit from the superlative liquidity offered by Liquid ETF investments and better optimize capital to generate further profits.

In terms of the expenses associated, the outgo is nominal, as can be seen from the chart below. Within the liquid fund ETF universe, ICICI Prudential offers the cheapest ETF with a total expense ratio of just 0.25%

Furthermore, in case of any short-term contingency, these Liquid ETF units can be sold freely on the spot market and readily converted back into cash for further usage. Moreover, they are cheaper than overnight mutual funds since there is no security transaction tax (STT) applicable on the purchase or sale of Liquid ETF units.

While returns on Liquid ETFs can’t be compared with those offered by other category debt mutual funds, the overall value proposition provided by liquid ETFs makes it an indispensable instrument for large retail traders and investors, F&O participants, brokers, and institutions which invest directly in equities.

On the other hand, if you are an investor wondering where to park capital for a short time and looking for a return profile better than a traditional investment option, then a liquid ETF can be a viable option.