Arbitrage Funds vs Liquid Funds, Which fund suits you best?

While choosing the right investment option most suited to meet your short-term investment need most of you tend to invest in Bank FD or savings account. However, there are other short-term investment avenues which you can and should explore for your short-term investments. Arbitrage funds and liquid funds are two such investment options which can be considered to meet your short-term investment needs.

Arbitrage funds

These are mutual fund schemes which leverage on the price differences in two different markets and thereby earn profits. As arbitrage funds are involved in simultaneous buying and selling of shares and making profits from market inefficiencies, they are considered to be low-risk investments and a safe option to park funds. The returns generated by these funds depend on the volatility of the underlying asset.  As these funds primarily invest in equities, they are categorized as equity mutual funds and taxed like any other equity mutual fund.

Liquid funds

Liquid funds, on the other hand, are open-ended debt schemes, that invest money in debt instruments such as treasury bills, commercial papers, certificate of deposits and even term deposits etc. Liquid funds are extremely liquid in nature and have no exit load. The redemptions are processed within 24 hours.

Which fund to choose- Arbitrage Fund or Liquid Fund?

Arbitrage funds gained a lot of popularity after the Union Budget of 2014 when the minimum holding time for long-term capital gains on all debt investments was increased from 1 year to 3 years and long-term tax on equities was nil. However, now under the new budget, even gains from arbitrage funds would be taxed; 10% if sold after a year and 15% if the holding period is less than a year.

While both arbitrage funds and liquid funds are low-risk, low-return type of investment, there are few things you must compare and choose the investment option most suited to meet your needs.

Time Horizon of Investment

One of the most important things to consider before making a choice between the two is the time horizon for which you are looking to invest. If you are looking to invest for a few days or weeks, then it is advisable that you invest in liquid funds.  Returns from arbitrage funds are dependent on arbitrage opportunities available, which are few. Thus, for such a short time you may not be able to generate any returns from such funds and hence more suited for investors who are looking to invest for a period of at least 3 months or more.

Tax efficiency

Before you choose to invest in either of the two options, understand the tax implications on your returns. Short-term capital gains on arbitrage funds are taxed at a flat rate of 15% and those from liquid funds are clubbed with your total taxable income and taxed as per your income tax slab. Thus, the tax efficiency of the investment will primarily depend upon the tax bracket that you fall under. For low-income investors liquid funds are more tax efficient as compared to investors in the highest tax bracket. Similarly, arbitrage funds are more tax efficient than liquid funds for investors who are in the tax brackets of 20% and above as the short-term capital gains tax is 15% which is lower.

Liquidity of investment

Liquid funds score over arbitrage funds when it comes to liquidity. Redemptions in liquid funds are processed within 24 working hours but in case of arbitrage funds, the redemption is made within 3 to 5 working days.

Returns

The returns generated by arbitrage funds are slightly higher than liquid funds, especially in volatile market conditions when ample arbitrage opportunities exist.

Risk

Liquid funds and arbitrage funds are both low-risk investment options but arbitrage funds are slightly more risky than liquid funds. While returns on liquid funds are similar to those of bank FDs, returns in case of arbitrage funds are dependent on the arbitrage opportunities available in the market, which are erratic.

Exit Charges

The exit charges in case of liquid funds are nil, but there is usually a pre-mature withdrawal charge in arbitrage funds if the withdrawals in the first few months.

Conclusion

The choice of investment most suited for you will depend on your individual investment objective. Ideally, investors looking to invest for a period of 6 months or more, especially those in the highest tax bracket should opt for arbitrage funds for better returns and higher tax-efficiency; and those investors looking to invest for shorter time frame or those in lower income brackets can look at investing in liquid funds in order to make the most from their investment.