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When it comes to parking funds for short periods of time, what is important for investors is to concentrate on liquidity, stability, instead of returns. The tricky part is in selecting an investment option that aligns with your time horizon and risk tolerance. Some investors might be more worried about safety than profits, but others are willing to take a bit more risk in order to increase their profits. Mutual funds with similar risk and reward potential that are frequently employed for short-term investing are arbitrage and liquid funds. This blog helps you choose the best short-term investing option by analysing liquid and arbitrage funds.
What are Arbitrage Funds?
Arbitrage funds must have at least 65% of their total assets invested in stocks or equity-related investments, making them hybrid funds according to the Securities and Exchange Board of India (SEBI). Taking advantage of price differences between the stock, cash, and futures markets is the main tactic used by these funds. In the case of arbitrage funds, the mutual fund company purchases stocks in one market and then sells them in another, profiting on the price differential.
For instance, if a stock of HDFC Bank is priced at Rs. 1000/- in the cash market and Rs 1020/- in the futures market. The arbitrage fund makes a profit of Rs 20/- by purchasing it from the former and selling it from the latter. The price difference of Rs 20/- represents the fund's return. This approach reduces overall risk by producing steady returns without sacrificing the market-neutral approach.
Pros and Cons of Arbitrage Funds
|
Pros |
Cons |
|
Arbitrage funds are Market-neutral, reducing market risk. |
In arbitrage funds, returns can be limited during low volatility and lower risk. |
|
It has the potential for consistent returns through price inefficiencies in two markets. |
It has a high transaction cost due to frequent trading. |
|
Tax is on the lower side. Long-term capital gains tax at 12.50% after one year. |
Returns depend on market volatility for profitability. |
|
It provides diversification between equity and derivatives. |
Investment requires an understanding of complex market dynamics. |
What are Liquid Funds?
SEBI classifies liquid funds as debt funds, and they invest in short-term market instruments such as government securities (G-Secs), treasury bills (T-bills), and commercial papers (CPs). They mature in ninety-one days or shorter. Redemption, however, is possible on a one-day T+1 basis. As a result, they have greater liquidity than other mutual fund kinds.
The shorter period of these investments significantly lessens the impact of changes in interest rates. For investors who need quick access to their money, liquid funds are reliable and risk-free investment choices.
Pros and Cons of Liquid Funds
|
Pros |
Cons |
|
Liquid Mutual Funds are highly liquid and can be redeemed quickly. |
Returns of liquid funds are lower than equity or arbitrage funds. |
|
Liquid funds invest in short-term, low-risk debt instruments. |
It is sensitive to rising interest rates. |
|
It provides stable and predictable returns. |
It has minimal credit risk due to shorter tenure but some exposure to defaults. |
|
It has no lock-in period, making funds accessible at any time. |
Short-term /Long-term capital gains tax as per the current rules (Taxed at 12.50% or slab rate) |
Let’s understand the differences between Arbitrage Funds and Liquid Funds
|
Aspect |
Arbitrage Funds |
Liquid Funds |
|
Category |
Hybrid Fund (Equity & Debt) |
Debt Fund |
|
Investment Strategy |
Encash the price differences between cash and futures markets |
Invests in short-term debt instruments like commercial papers, government securities, and treasury bills |
|
Risk Level |
Low to moderate risk, market-neutral strategy |
Very low risk, focused on short-term debt
|
|
Liquidity |
Moderate, with redemption typically in 2-3 business days |
High, with redemption on a T+1 basis |
|
Return Potential |
Moderate, depends on market volatility and pricing difference |
Low, stable returns with minimal fluctuations |
|
Ideal For |
Investors looking for steady returns with moderate risk |
Conservative investors looking for safe and liquid short-term investment |
|
Market Dependency |
Dependent on market volatility for profitability |
Not significantly impacted by market conditions |
|
Investment Tenure |
Medium- to long-term |
Short-term (typically less than 91 days) |
Arbitrage Funds Vs Liquid Funds – What Should You Choose?
The returns you can obtain after expenses and taxes are compared when comparing various mutual fund types. Due to their comparable risk-reward characteristics, arbitrage and liquid funds are both beneficial for short-term parking. One of the safest investing options is liquid funds, but the main concern is whether they are tax-efficient over a shorter investment time.
Returns
Due to their equity exposure, arbitrage funds are highly correlated with the market and may experience short-term volatility. However, in terms of returns, liquid funds are more reliable. Nonetheless, the short-term returns from liquid funds and arbitrage are similar.
Cost
The cost of investing in mutual funds is determined by the expense ratio. Liquid funds have a lower expense ratio than arbitrage funds. Consequently, liquid money is less expensive. Additionally, there are no penalties associated with withdrawals from liquid funds because their primary function is to provide the ability to cash out at any moment in the event of need without incurring an exit fee. The exit load will otherwise apply; therefore, you might have to wait up to 15-30 days for arbitrage funds.
Tax Implications
Being a type of Equity Mutual Fund, Arbitrage mutual funds are taxed like equity funds in India.The
- Short-Term Capital Gains (STCG) period is less than 12 months and is taxed at 20%.
- Long-Term Capital Gains (LTCG) is over 12 months and taxed at 12.5% with an exemption of up to Rs. 1.25 lakh per financial year.
In case of Liquid Mutual Funds:
|
Purchase Date |
Holding Period |
Tax Treatment |
|
Before 1st April 2023 |
Up to 24 Months |
STCG: As per Investor’s Slab Rate |
|
|
Over 24 Months |
LTCG: 12.5% without indexation |
|
On or After 1st April 2023 |
Any Duration |
STCG only: Always taxed at slab rate; no LTCG benefit |
Conclusion
Your needs and emergency financial requirements will determine whether you should invest in liquid funds or arbitrage. For high-income earners, arbitrage funds provide steady returns with reduced risk and improved tax efficiency. If you wish to swiftly and penalty-free redeem your units after a short period of time, liquid funds are an excellent choice. However, because their profits are included in your taxable income and subject to taxation, liquid funds are less tax-efficient. Investors must consider all the advantages and disadvantages before selecting one based on their financial objectives and tax planning approach.
You can also watch: "Debt Trap Reality: The ₹10 Crore Financial Secret | Good Loan vs. Bad Loan."
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