Arbitrage Fund vs Liquid Fund – Which one should you choose?


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.
- Table of contents
- What are arbitrage funds?
- What are liquid funds
- Arbitrage funds and liquid funds: Know the key differences
- Comparing arbitrage funds to liquid funds
- How to Invest in Arbitrage and Liquid Funds
- Benefits of Arbitrage Funds and Liquid Funds
- Who Should Invest in Arbitrage Funds vs. Liquid Funds?
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.
Comparing arbitrage funds to liquid funds
Arbitrage funds actively seek out and exploit market inefficiencies, while liquid funds focus on capital preservation and liquidity
Here's a comparison between the two funds:
Feature | Arbitrage Funds | Liquid Funds |
---|---|---|
Investment Strategy | Exploit price differences between cash and derivatives markets | Invest in short-term, low-risk debt instruments (T-bills, commercial paper) |
Risk Profile | Generally considered low risk, but slightly higher than liquid funds due to market volatility | Very low risk |
Liquidity | Generally liquid, but may take a few business days for redemption | Highly liquid, with fast access to funds |
Return Potential | Potentially better returns than liquid funds, but can be impacted by market volatility | Lower returns compared to arbitrage funds, but generally higher than savings accounts |
Taxation | Taxed as equity (more tax-efficient than liquid funds) | Taxed as per income tax slab |
Suitability | Investors seeking slightly better returns than liquid funds with a moderate risk appetite | Investors prioritizing liquidity, low risk, and short-term parking of 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.
How to invest in arbitrage and liquid funds
Steps to invest in arbitrage and liquid funds:
1. Choose a platform
You can choose to invest through a distributor, online third party platforms, or directly through the AMC’s website.
2. Open an account
KYC/AML: Complete the Know Your Customer (KYC) and Anti-Money Laundering (AML) procedures by submitting documents like PAN, Aadhaar, and address proof.
3. Research and select funds
Arbitrage funds:
Consider factors: Look at past performance, expense ratio, fund manager's track record, and AUM (Assets Under Management).
Research: Use online resources and financial publications or consult a financial advisor for guidance.
Liquid funds:
Consider factors: Focus on expense ratios, credit quality, and liquidity of the underlying securities.
Research: Compare different funds based on these criteria.
4. Choose investment type
Lump sum: Invest a specific amount at once.
Systematic Investment Plan (SIP): Invest fixed amounts at regular intervals (e.g., monthly or quarterly).
5. Invest
Place order: After selecting the fund and amount, place the order through your chosen platform.
Confirm order: Review and confirm the order details before submitting.
6. Monitor your investments
Track performance: Regularly monitor the performance of your investments and compare them with benchmarks.
Rebalance: Periodically rebalance your portfolio to maintain your desired asset allocation and risk profile.
Benefits of arbitrage funds and liquid funds
Benefits of arbitrage funds:
Relatively low risk: Arbitrage funds leverage price differences between cash and derivatives markets, minimizing market exposure.
Potential for steady returns: These funds provide consistent returns by utilizing market inefficiencies, even during volatile periods.
Tax advantages: As equity funds, arbitrage funds offer favorable tax treatment for long-term gains.
Benefits of liquid funds:
High liquidity: These funds allow quick access to your investments when needed.
Low risk: They invest in short-term, low-risk debt instruments, reducing the risk of capital loss.
Returns: Liquid funds typically outperform savings accounts. However, unlike savings account, returns from liquid funds are not guaranteed.
Short-term suitability: Perfect for emergency funds, parking surplus cash, or achieving short-term financial objectives.
Who should invest in arbitrage funds vs. liquid funds?
Arbitrage funds: Suitable for moderate risk-takers seeking steady, tax-efficient returns. Suitable during market volatility for relatively stable investments.
Liquid funds: Suitable for low-risk investors needing high liquidity for short-term goals. Useful for emergency funds with stable, predictable returns.
Conclusion
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.
What kind of returns can I expect from Arbitrage Funds?
Arbitrage funds exploit price differences between markets to generate returns, typically offering moderate returns with low volatility. Historically, their returns have been higher than short-term debt funds. Taxed like equity funds, they may offer tax advantages. However, returns depend on market conditions and there are no guarantees.
Is there any risk involved in Liquid Funds?
Liquid funds are low-risk but carry some risks, including interest rate, credit, inflation, liquidity, and market risks. While interest rate hikes and inflation can affect returns, liquidity risks are typically minimal. Credit and market risks are also limited due to the high-quality nature of the debt instruments.
Can I invest in both Arbitrage and Liquid Funds?
Investing in both Arbitrage and Liquid Funds offers diversification and balanced risk management. Liquid Funds provide stability and liquidity, while Arbitrage Funds may yield relatively better return potential. Allocating based on risk tolerance and periodically rebalancing can optimize your portfolio.
What are the benefits of investing in Liquid Funds?
Liquid funds offer high liquidity, allowing quick access to funds, low risk with investments in short-term debt instruments, and better return potential. They are convenient for short-term goals and provide diversification.
Are Arbitrage Funds suitable for beginners?
Arbitrage Funds may not be suitable for beginners due to their complexity and the need for a better understanding of derivatives and risk. Beginners may find Liquid Funds, Index Funds, or shorter-duration Debt Funds more suitable for starting. Always consult a financial advisor to make informed investment decisions.
How do Arbitrage Funds generate returns?
Arbitrage funds exploit price discrepancies between markets to generate profits. The fund buys securities at a lower price in one market and sells them at a higher price in another, profiting from the difference. While theoretically risk-free, these opportunities are rare due to market efficiency and rely on skilled fund managers.
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.