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Let’s discuss Arbitrage funds Vs Liquid funds to know which is a better investment option. Arbitrage Funds purchase shares in the cash segment and sell derivatives in futures. It generates great returns for investors by leveraging the price difference of the two segments.

Liquid funds invest money in short-term market instruments like treasury bills, commercial papers, and government securities. These debt mutual funds invest in instruments with a maturity of up to 91 days. Fund Managers leverage the lower maturity period to meet the redemption demand from investors.

While Arbitrage Funds are equity-focused mutual funds; liquid funds are debt-based mutual funds. Arbitrage funds put your investments at a lower risk in comparison to liquid funds. You can encash the price difference between the cash and future segments of an asset by investing in Arbitrage funds. While Liquid funds are an open-investment debt scheme to invest in short-term market instrument schemes.

What are Arbitrage Funds?

Arbitrage Funds are hybrid funds that invest majorly in equities and leverage arbitrage opportunities in the market. They generate returns from a pricing mismatch between two exchanges. For instance, the difference may be in the pricing of cash and futures market. The fund manager of an arbitrage fund earns the difference amount for you by buying and selling the shares at the same time. The difference between the selling price and the buying price of the share is your earning. This is a fundamental differentiation point from all other forms of investing. Unlike the regular process of purchasing an asset and waiting for its value to increase before selling. The fund manager of an arbitrage fund invests in equities only when the opportunity to earn returns is certain. In case there are no arbitrage opportunities, then the fund manager invests in other options. These may be short-term money market instruments and debt securities. As the price difference of an asset in different segments is usually very small. The fund manager makes several trades in a day to book a reasonable profit for your investment.

Who Should Invest in Arbitrage Funds?

The risk profile of an arbitrage fund is similar to that of a debt fund. These funds generally use the Liquid Fund Index as a benchmark. You must invest in arbitrage funds if you want to invest in equity but don’t want to bear the risks. Risk-averse investors can park their money in an arbitrage fund when the market is fluctuating and earn good returns.

What are Liquid Funds?

Liquid funds are high in liquidity and ideal for short-term investments. They are a class of debt funds that invest in fixed-interest generating money market instruments. Treasury bills, commercial paper, and so on are examples of the underlying securities in the portfolio of a liquid fund.

Who Should Invest in Liquid Funds?

Liquid funds are suitable for investors with idle cash for investing in short-term options. Investors must invest in liquid funds instead of parking surplus funds in a savings bank account. Liquid funds earn much higher returns than savings bank accounts and other term deposits. Your surplus funds could be a result of performance-based incentives, bonuses, and gains made by selling capital assets. Liquid funds invest majorly in equity funds. You may also invest the money in a liquid fund initially and then systematically transfer it to an equity fund of your choice over a specified period.

Arbitrage Funds vs Liquid Funds

Following are the main differences between Arbitrage funds Vs Liquid funds:

Liquidity of your Investment

Under certain situations, an investor would want to encash their investment as soon as possible. This requirement of the investor is called the liquidity of a fund. Liquid funds are far better than arbitrage funds in terms of liquidity. An arbitrage fund takes at least 3 to 5 days for redemption while liquid funds can be encashed within 24 hours.

Return on Investment

Investors would expect a healthy return on their investment when they choose short-term investment options. Arbitrage funds give better returns than liquid funds. They perform better in volatile markets as there are ample arbitrage encashment opportunities in the market.

Risk Factor

Liquid funds are much safer in comparison to arbitrage funds, as it invests mainly in debt-related instruments. While arbitrage funds are riskier as the investment returns are dependent on the market volatility. The fund managers get ample arbitrage opportunities during a bullish market. They try to maximize the difference between the cash and futures market to generate greater returns.

Investment Horizon

The investment horizon for liquid funds varies from a few days to a few weeks. But an ideal investment period in the arbitrage fund wouldn’t be so short. You must invest for at least 3 months or more to enjoy great returns on your investment. In case you invest for a short span of time in Arbitrage funds, they will fetch erratic returns on your investment. 

Exit Charges

An Asset Management Company (AMC) charges a fee from the investor at the time of exiting or redeeming the fund. Liquid funds usually do not charge any exit penalties. While you must pay charges of 0.25% to 0.5% if you want to exit from Arbitrage funds. These charges are applicable when you plan to exit within the first three to six months (premature withdrawal) of the investment.

Tax Benefits

This is one of the key differences between Arbitrage and Liquid funds. Your tax bracket defines the tax benefits of a liquid fund. The short-term returns generated from these funds are your income and must be taxed accordingly. Consequently, you may find it inefficient if you are in the highest tax bracket. While a non-earning individual will find it efficient.

On the other hand, arbitrage funds will attract a flat 15% tax on short-term capital gains (period of less than 1 year) from the investment date. This is quite low in comparison to the 20% tax in liquid funds. However, if you invest in arbitrage funds for more than 1 year, your gains will be eligible for long term capital gains (LTCG). If your gains are above the value of Rs. 1 lakh, tax at the rate of 10% will be applicable without any single benefit of indexation.

Conclusion

Fund managers conduct thorough market research for Arbitrage funds while a liquid fund portfolio comprises top-rated money-market instruments. Arbitrage funds channelize your money more efficiently than any other mutual funds, amid price volatility in the market. You must consider your financial requirements and goals for your investment. You can also decide upon a period of investment before actually investing in either of these mutual fund schemes.