For the short-term investment planning investors prefer Arbitrage funds and often compare them with Liquid funds. Arbitrage funds work differently. The fundamental philosophy on which they are based is riskless profit. They work on the mispricing of equity shares in the spot and futures markets. The aim is to gain from the price differences between current and future securities to optimize profits. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives markets. Arbitrage funds are hybrid funds that invest in equities and leverage arbitrage opportunities in the market.
Liquid funds are debt funds that invest in debt and money market securities like corporate bonds, treasury bills, commercial paper, government securities etc. A Liquid fund’s portfolio matures in 91 days on an average. They are high in liquidity and ideal for short-term investments.
The major differences between the two-
- Risk and Returns: Liquid funds are comparatively safer than arbitrage funds. The maturity period in case of liquid funds is shorter i.e., 91 days. An Arbitrage fund invests in equity and depends on arbitrage opportunities. However, the returns generated from both types of funds are in the range of 4-7% over the long term. With one exception though being that arbitrage funds can use arbitrage opportunities to deliver better short-term returns. The fund managers get ample arbitrage opportunities during a bullish trend, and they try to maximize the difference between the cash and futures market to generate greater returns.
- Applicable tax rates: Arbitrage funds are treated as equity funds while computing your return of income. Arbitrage funds may be more tax efficient depending upon your tax slab. Your tax bracket can decide which one will give you more benefits. The following chart shows how both types of funds are taxed.
| Tax | Arbitrage Fund | Liquid Fund |
| STCG | 15% | As per Income Tax slab |
| LTCG | 10% | As per Income Tax slab |
- Liquidity: As the name implies, Liquid funds are better than Arbitrage funds from liquidity point of view. If you want to withdraw your money from an arbitrage fund, it will take 3-5 days to withdraw money. But it will take 1-2 days to withdraw your money from a liquid fund. Some of the liquid funds come a with an instant redemption feature too.
- Expenses: Arbitrage funds have a comparatively higher expense ratio than liquid funds as its functionality depends heavily on the fund manager’s ability to use arbitrage opportunities to earn more profits.
- Duration of investment: Duration of investment in liquid fund ranges from a few days to a few weeks. Whereas in case of an arbitrage fund it will be longer than this duration. You need to stay invested for at least 3 months or more to earn higher returns on your investment. Investing for a shorter period result in erratic yields.
| Parameter | Arbitrage Fund | Liquid Fund |
| Fund type | Hybrid | Debt |
| Invests in | Equity, Debt | Debt |
| Risk | Moderately low | Low |
| Returns | Uncertain | Consistent |
| Ideal for duration | 3 + months | 1-3 months |
| Taxed as | Equity Fund | Debt Fund |
| Average returns | 4-6% | 4-7% |
| Indexation benefits | Yes | Yes |
Which one should you consider for investing?
Though arbitrage funds can yield comparatively better returns than a liquid fund, a liquid fund is generally more stable and consistent in terms of returns. They have more liquidity too. Most liquid funds do not charge any exit fee for redemption after 7 days. But an exit fee is charged in case of an arbitrage fund. But looking from the taxation angle, arbitrage funds look better than liquid funds. Depending on your tax bracket you may choose to invest in arbitrage funds if you fall into a higher tax slab. Because liquid funds will be tax efficient only if you are a non-earning individual. Liquid funds are tax inefficient if you are in the highest tax bracket. If you invest in arbitrage funds, your gains above Rs. 1 lakh will be taxed at the rate of 10% without indexation.
Who should invest in Arbitrage fund? -If you want to invest in equity but do not want to bear the risks, then arbitrage funds are the right choice for you. They are meant for risk-averse investors when the market is volatile, but they want to earn good returns.
Who should invest in Liquid Funds? -Liquid funds are for those investors who have idle cash for investing in short-term options. Instead of keeping the funds idle in the savings bank accounts, investors must invest in liquid funds. Liquid funds earn much more than the savings bank accounts and other term deposits. You may eventually shift to equity funds after you gain some confidence by investing in liquid funds.
While arbitrage funds use your money more efficiently than any other mutual funds amid price volatility in the market, liquid funds help you earn moderate returns during a shorter span of three days keeping the risks at bay. Thus, period of investment, your financial goals, taxation and risk profile are some of the factors that will determine which kind of funds out of the above two, suits you more. It should be noted that both arbitrage funds and liquid funds may offer you better returns as compared to band savings account of fixed deposits. They both carry a lower risk compared to other mutual fund at the same time.
Bhoi Smrutirekha Dharanidhar