All you need to know about arbitrage funds and liquid funds

As a new investor, entering the mutual fund market might seem like a daunting task as there are many types of funds, each with its own merits and demerits. But in this overload of information, there is one debate that keeps popping up whenever there is a discussion on investments – what is the difference between arbitrage funds and liquid funds.

An arbitrage fund is a mutual fund that seeks to generate returns by taking advantage of pricing disparities across market, while a liquid fund prioritises high quality and high liquidity. By understanding the differences between these two types of funds, investors can make informed decisions about how to allocate their investments.

What are arbitrage funds?

Arbitrage funds are a type of hybrid mutual fund that leverages the price difference between two markets – namely, the cash and futures markets – to generate returns. Let’s understand the concept of arbitrage funds with the help of an example. Imagine you buy a shirt at Rs.200 from a market and sell it at another marketplace at Rs.210. This results in riskless profit/arbitrage of Rupees 10.

In simple terms, an arbitrage fund takes advantage of price differences in two markets to make a profit. Moreover, arbitrage funds invest in both the equity and derivatives markets.

What are liquid funds?

A liquid mutual fund invests in short-term debt instruments with a maturity period of up to 91 days. Liquid funds are ideal for investors looking for high liquidity, low risk, and commensurate returns. Plus, liquid mutual funds invest in money market instruments such as treasury bills, commercial papers, and certificates of deposit.

Investors can consider investing in both liquid and arbitrage fund as per their preference. However, to make an informed decision, the investor must understand the key differences between an arbitrage fund and a liquid fund.

Arbitrage funds and liquid funds: Know the key differences

• Investment objective: The primary objective of a liquid fund is to provide liquidity and mitigate impact on capital, while the primary objective of an arbitrage fund is to generate returns through arbitrage opportunities.
• Investment horizon: Arbitrage funds have a short-term investment horizon of around 3 months and above, while liquid funds have an indicative horizon of 7 days and above.
• Returns: Arbitrage funds have the potential to generate slightly better returns than liquid funds. However, liquid funds are comparatively stable and consistent in terms of generating returns.
• Taxation: Arbitrage funds are taxed as equity funds, while liquid funds are taxed as debt funds. Therefore, the tax implications of investing in these funds are different. Investors are recommended to consult their tax consultants for better understanding their specific tax applicability.
• Investment risk: In case of liquid funds, there is minimal credit risk and interest rate risk since they invest predominantly in debt instruments for up to 91 days. On the other hand, arbitrage funds maintain fully hedged investment positions by holding reverse positions in the cash and futures market. Thus, there is negligible investment risk in case of arbitrage funds.

However, choosing between liquid funds and arbitrage funds should not be based on just the advantages and disadvantages of the two fund types. Since each investor has their own unique objective, a careful analysis is needed before putting one’s money into a scheme.

Both arbitrage and liquid funds are short-term parking option for surplus cash and may not be ideal for long-term financial goals. Though an arbitrage fund may offer better outcome than a liquid fund, it may also be subject to market fluctuations that can affect returns. On the other hand, a liquid fund may offer lower returns than an arbitrage fund, but it provides better stability and liquidity.

In the end, investors must decide which type of fund aligns best with their investment objective and risk tolerance. With careful consideration and planning, investors can build a diversified portfolio that includes both arbitrage funds and liquid mutual funds, helping them achieve their financial objectives.

Investing in Bajaj Finserv Liquid Fund can help investors meet their short-term investment needs. This scheme aims to provide the investors steady income with the preservation of capital, lower risk, and high liquidity.

FAQs:

What is an example of a liquid fund?

Liquid funds are mutual funds that invest primarily in debt and money market instruments with a maturity of up to 91 days. These funds are a good option for investors looking for short-term investments with relatively lower risk.

Is liquid fund better than arbitrage fund?

Both liquid fund and arbitrage fund serve a similar purpose of short-term parking of surplus cash. While investment horizon of liquid fund is 7 days and above, arbitrage funds have an indicative investment horizon is 3 months and above. The suitability of each depends on the investor's preference and risk appetite.

Is it good to invest in arbitrage funds?

Investing in arbitrage funds can be a good option for investors looking for low-risk investments with commensurate returns. These funds can help minimize market volatility and generate returns through the price differential between cash and derivatives markets.

Are liquid funds tax free?

Liquid funds are a type of debt funds, and hence are taxed similarly. The gains from liquid funds are subject to taxation as per the investor's income tax slab. It’s recommended to seek the help of a tax consultant for better understanding of the same.

Mutual Fund Investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as an investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.