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Liquid v/s Arbitrage Funds

Liquid v/s Arbitrage Funds

As a beginner investor, you’re most likely looking for investment avenues that offer good returns at low risk. If you’re looking to park your funds for the short-term, your top choices are either liquid funds or arbitrage funds. While liquid funds invest in debt securities, arbitrage funds invest across debt and equity and aim to generate returns through arbitrage opportunities in the cash and futures market, thus maintaining fully hedged positions. Even so, both are considered non-volatile investing modes and even offer similar returns.

The natural question then – as an investor, which one should you choose?

In this article, we review liquid and arbitrage funds and their differences. We also tell you which funds to invest in.

What are liquid funds?

Categorised as debt funds by the Securities and Exchange Board of India (SEBI), liquid funds invest in short-term market instruments like commercial papers, government securities and security bills. Although these instruments mature within 91 days, investors can redeem their returns on T+1 basis. This way, liquid funds offer higher liquidity compared to other investment avenues. Besides, the investors benefit from lower interest rate fluctuations given the lesser tenure.

What are arbitrage funds?

Categorised as hybrid funds, arbitrage funds must have 65% of the fund assets in equities or equity-related securities as per SEBI mandates. Here, the returns are generated from a pricing mismatch between purchases made in the cash market and sales made in the future’s market. For instance, an asset may have a value of Rs. 15 in market A and Rs. 20 in market B. So, if you buy the asset from market A and sell it in market B, you make a profit of Rs. 5. These are your returns.

Difference between liquid and arbitrage funds

1. Liquidity: Arbitrage Funds vs Liquid Funds

As their name suggests, liquid funds offer better liquidity than other short-term investment avenues. Usually, the redemption amount is disbursed to the investor’s bank account on a T+1 basis or the next working day, provided the transaction is received before the cut-off time.

In contrast, redemption occurs on a T+3 basis in the case of arbitrage funds.

This makes liquid funds a preferred investment avenue for investors who want high-liquidity investments.

2. Returns: Liquid Funds vs Arbitrage Funds

Since liquid funds invest in debt investment instruments that are less volatile than stocks, the returns are more stable and consistent.

In contrast, arbitrage funds invest in equity instruments that are known to offer better returns. But instead of being highly volatile like other equity instruments, arbitrage funds have almost no investment risk. This is because these investments hedge risks by buying one instrument and selling them quickly.

3. Exit Load: Liquidity Withdrawal Charges Compared

Most Asset Management Companies (AMCs) charge investors an exit fee when they exit or redeem the fund. That said, liquid funds are typically not associated with exit penalties unless investors redeem their funds within seven days of investing.

In the case of arbitrage funds, investors must pay fees to exit the fund. Note that these charges are applicable if the investor exits the fund within a few weeks after investing. Also, the period after which exit charges are applicable depends on the asset management company.

4. Risk: Volatility & Market Impact on Both Fund Types

Liquid funds, being debt funds, have interest rate and credit risk. This means your returns may get affected due to a rise in interest rates if the issuer loses its financial stability.

In contrast, arbitrage funds come with no price fluctuation risk, despite being equity-oriented hybrid funds. This is because these funds are 100% hedged, given the buying and selling of assets occur quickly.

5. Taxation: Liquid Funds vs Arbitrage Funds in India

Since the SEBI classifies liquid funds as debt funds, their returns are added to the investor’s taxable income for the financial year. Whether you invest for a short-term or long-term, you must pay taxes according to the tax slab applicable to your overall earnings in a financial year.

Arbitrage funds are taxed as equity funds. This means the STCG earned when funds are held for less than a year are taxed at 15%, whereas gains earned after holding funds for over a year are taxed under LTCG. Accordingly, if the gains are above Rs. 1 lakh, the tax is at a rate of 10%.

Arbitrage Funds vs Liquid Funds: Which Gives Better Returns?

Both investment avenues have their pros and cons. That said, opt for liquid funds if you want to invest in low-risk debt funds, want higher liquidity, and don’t want to pay an exit load on short-term investments that last a few weeks. But if you want to invest in a low-risk, high-return investment avenue, and don’t mind lower liquidity, invest in arbitrage funds.

Now, whether you’re looking to invest in liquid or arbitrage funds, you need a reliable investment partner to help you with your journey. If you’re looking for one, turn to Tata Capital Wealth. We allow customers to access their portfolio at their convenience through the Tata Capital Wealth Portal, offer relationship management services, and provide informative and qualitative reports to help you make the right investment decisions.

Who Should Invest in Liquid Funds and Arbitrage Funds?

Both liquid and arbitrage funds serve short-term investment needs, but they suit different investor profiles.

1. Liquid funds are suitable if you want quick access to your money while earning slightly better returns than a savings account. They work well for emergency funds, surplus cash, or short-term goals lasting a few days to a few months.

2. Arbitrage funds are better suited if you can stay invested for a few months and are looking for relatively higher post-tax returns. They are often preferred by investors in higher tax brackets who want equity-style taxation with controlled risk.

3. Your choice depends on liquidity needs, tax bracket, and investment horizon, rather than just return expectations.

Pros & Cons Table: Arbitrage Funds vs Liquid Funds

Here’s a side by side comparison of what advantages and limitations each type of fund is associated with: 

ParameterLiquid FundsArbitrage Funds
LiquidityVery high, usually T+1 redemptionLower, typically T+3 redemption
Risk LevelLow, subject to interest rate and credit riskLow, but depends on arbitrage opportunities
Return StabilityStable and predictableCan vary based on market conditions
Exit LoadUsually none after a few daysMay apply for short holding periods
TaxationTaxed as per income tax slabTaxed as equity funds
Ideal Holding PeriodFew days to a few monthsFew months to one year

Conclusion

Liquid and arbitrage funds are both suitable for short-term investing, but they cater to different priorities. Liquid funds work well when access to funds and stability matter more, while arbitrage funds can be useful when tax efficiency and slightly higher returns are the goal.

If you are evaluating these options as part of a broader investment strategy, Tata Capital Wealth can support you with expert guidance. Through personalised advisory services and a convenient digital platform, Tata Capital helps you make informed investment decisions aligned with your financial goals.

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FAQs

What is the main difference between arbitrage funds and liquid funds?

The main difference lies in where they invest. Liquid funds invest in short-term debt instruments, while arbitrage funds invest in both equity and debt to benefit from price differences between markets.

Are arbitrage funds safer or riskier than liquid funds?

Both are considered low-risk. Liquid funds face interest rate and credit risk, while arbitrage funds depend on market conditions but remain hedged, which limits volatility.

Which is better for short-term parking: liquid or arbitrage fund?

Liquid funds are usually better for very short-term parking due to faster liquidity. Arbitrage funds may suit you if you can stay invested slightly longer and want tax efficiency.

How are liquid funds and arbitrage funds taxed in India?

Liquid fund returns are taxed as per your income tax slab. Arbitrage funds follow equity taxation rules, with short-term and long-term capital gains taxed differently.

Can arbitrage funds give negative returns?

While rare, arbitrage funds can deliver marginally negative returns in unfavourable market conditions, especially over very short periods when arbitrage opportunities are limited.

Why do arbitrage funds sometimes outperform liquid funds?

Arbitrage funds can outperform liquid funds due to equity-style taxation and opportunities created by price differences between cash and futures markets, particularly during volatile market phases.

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