Arbitrage Funds vs Liquid Funds- Investors must focus on liquidity, stability, and returns when parking funds for short periods. However, the problem is choosing an investment option that fits your risk appetite and time horizon. While some investors may focus more on safety than returns, others may be willing to take a little more risk to make some more gains.
Arbitrage and liquid funds are mutual funds widely used for short-term investments with comparable risk and reward potential. This blog compares arbitrage funds vs liquid funds to help you make the best decision for your short-term investment.
What are Arbitrage Funds?
Arbitrage funds are hybrid funds, as classified by the Securities and Exchange Board of India (SEBI), and at least 65% of the fund’s total assets must be invested in equities or equity-related investments. The primary strategy of these funds is to exploit price mismatches between the cash and futures markets for stocks. For arbitrage funds, the mutual fund house buys equities in one market and sells the same in another market, taking the price difference as profit.
For example, if the price of an asset in market A is Rs 50, and in market B, it is Rs 55. The arbitrage fund buys it from the former and sells it from the latter, earning a profit of Rs 5. The return for the fund is the price difference of Rs 5. It’s a strategy whereby consistent returns are generated without compromising the market-neutral standpoint, diminishing the total risk.
Pros and Cons of Arbitrage Funds
Pros:
- Market-neutral, reducing exposure to market risk
- Potential for consistent returns through price inefficiencies
- Long-term capital gains tax at 12.5% after one year
- Provides diversification between equity and derivatives
Cons:
- Returns can be limited during low volatility
- High transaction costs due to frequent trading
- Dependent on market volatility for profitability
- Requires an understanding of complex market dynamics
What are Liquid Funds?
Liquid funds, classified as debt funds by SEBI, invest in short-term market instruments like commercial papers (CPs), government securities (G-Secs), and treasury bills (T-bills). They have a maturity of 91 days or less. However, redemption can be done on a one-day T+1 basis. Hence, they are more liquid than other types of mutual funds.
These investments are shorter in duration, which considerably reduces the impact of interest rate fluctuations. Liquid funds are stable and risk-free investment options for investors who require immediate access to their money.
Pros and Cons of Liquid Funds
Pros:
- Funds are highly liquid and can be redeemed quickly
- Invests in short-term, low-risk debt instruments
- Provides stable and predictable returns
- No lock-in period, making funds accessible at any time
Cons:
- Returns are lower than equity or arbitrage funds
- Sensitive to rising interest rates
- Minimal credit risk but some exposure to defaults
- Short-term capital gains tax if held for less than 3 years
Key Differences Between Arbitrage Funds and Liquid Funds
| Aspect | Arbitrage Funds | Liquid Funds |
|---|---|---|
| Fund Category | Hybrid Fund (Equity & Debt) | Debt Fund |
| Primary Investment Strategy | Exploits price differences between cash and futures markets | Invests in short-term debt instruments like commercial papers, government securities, and treasury bills |
| Risk Level | Low to moderate risk, market-neutral strategy | Very low risk, focused on short-term debt |
| Liquidity | Moderate, with redemption typically in 2-3 business days | High, with redemption on a T+1 basis |
| Return Potential | Moderate, depends on market volatility and pricing mismatches | Low, stable returns with minimal fluctuations |
| Ideal For | Investors seeking steady returns with moderate risk | Conservative investors looking for safe and liquid short-term investment |
| Taxation | Long-term capital gains tax (12.5% after 1 year) | Short-term capital gains tax if held for less than 3 years |
| Market Dependency | Dependent on market volatility for profitability | Not significantly impacted by market conditions |
| Investment Tenure | Medium- to long-term | Short-term (typically less than 91 days) |
Which One is Right For You?
Comparing different types of mutual funds involves comparing the returns you can get after costs and taxes. Both arbitrage and liquid funds are helpful for short-term parking as they have similar risk-reward profiles. Liquid funds are one of the safest investment options, but the major question you have to ask is whether they are tax-efficient when the investment period is shorter.
#1. Returns
Arbitrage funds are more linked to the market due to their equity exposure and can be volatile in the short term. On the other hand, liquid funds are more stable when it comes to returns. However, in the short term, the returns from arbitrage and liquid funds are comparable.
The performance of arbitrage funds depends heavily on market volatility. During periods of high market activity, these funds can generate attractive returns by exploiting price differences. Liquid funds, meanwhile, provide predictable returns that are generally better than regular savings accounts but lower than equity-oriented investments.
#2. Cost
The expense ratio in mutual funds determines the cost of investment. Compared to arbitrage funds, liquid funds have a lower expense ratio. As a result, liquid funds cost less. Also, for withdrawals, there is no penalty involved in liquid funds, as the main purpose of such funds is to offer the option to cash out at any time in case of a need, without an exit load.
For arbitrage funds, you may have to wait for up to 30 days as the exit load will otherwise apply. This means if you need urgent access to your money within the first month, you might face additional charges that reduce your overall returns.
#3. Tax Implications
Arbitrage funds held for less than 3 years incur a short-term capital gain tax of 20%, while the short-term capital gains tax on liquid funds is calculated based on your applicable income tax slab rate. On the other hand, long-term capital gains made from arbitrage and liquid funds are taxed at 12.5% (after the Rs 1 lakh exemption limit) as of the latest 2024 budget update.
Before the 2024 budget update, arbitrage funds were more tax efficient as short-term gains were taxed at only 15%, and indexation benefits were available. However, now that indexation benefits are not applicable, investors must determine whether they want arbitrage funds or liquid funds.
When you choose to invest in mutual funds for the short term (less than a year), liquid funds are a safer bet if you are in a lower tax bracket. However, if you are in a higher tax bracket, such as 30% or more, arbitrage funds offer much better post-tax returns. The 20% short-term capital gains tax on arbitrage funds becomes more attractive compared to paying tax at your income slab rate of 30% or higher on liquid fund gains.
Final Thoughts
The right type of investment โ arbitrage or liquid funds โ depends on your needs and quick cash requirements. Arbitrage funds offer stable returns with better tax efficiency and lower risk for high-income earners. Liquid funds are a good option if you want to redeem your units quickly without penalty after a short duration.
However, liquid funds are less tax-efficient since their gains are added to your taxable income and taxed accordingly. Investors must weigh all the pros and cons and choose one based on their tax planning strategy and financial goals. Understanding your investment horizon, tax bracket, and liquidity requirements will help you select the fund that best meets your short-term financial objectives.
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