Arbitrage Funds vs Liquid Funds: Which is Better for You?

If you are looking for a low-risk investment option to park your hard-earned savings for the short-term, you may invest in liquid funds. But many tax conscious investors tend to choose arbitrage funds as they have lower tax rates. If you are confused and debating arbitrage funds vs. liquid funds, which is better, knowing the following features can help you make the right decision.

The liquid funds and arbitrage funds are a different category of funds; the liquid funds hold debt investments, whereas arbitrage funds invest in equities. The liquid funds generate returns by accruing interest from the underlying papers, and they invest only in high-quality papers for a short duration. And, therefore, they have a low-interest rate risk. Unlike other equity funds, arbitrage funds are at low risk. Arbitrate funds take advantage of the difference in the prices of securities in the cash and the futures market to generate returns.

Liquidity factor

When you invest in any fund, you may face a situation where you may want to liquidate the investment at the earliest. In terms of liquidity, liquid funds are considered better than arbitrage funds. You will need at least three to five days to redeem the arbitrage funds, whereas you can encash the liquid fund within one to two days.

Risk involved

In terms of risk factors, liquid funds are a much safer investment than arbitrage funds as they invest mainly in debt instruments. Whereas arbitrage funds depend on market volatility and arbitrage opportunities to generate returns.

Returns on investment

Experts suggest arbitrage funds give better returns than liquid funds if you are looking to park your funds for the short-term and get decent returns. When the market is unstable, the arbitrage funds leverage the opportunity to generate higher profits.

Tax Benefits

This is one of the key differences between arbitrage and liquid funds. In liquid funds, the tax on returns is as per the income tax bracket; the profits earned are added to your income, and it will be taxed accordingly. So, if you fall under a higher tax bracket, you may find the investment inefficient.The tax rate on arbitrage funds is the same as for equity funds. If you hold the funds for less than one year, it will attract Short Term Capital Gains Tax (STCG) of 15%, much lower than the 20% in liquid funds. If you hold the investment for more than one year, your gains will be categorized as Long Term Capital Gains (LTCG) and it will be taxed at 10% (if the returns earned per annum is more than Rs. 1 lakh) without the benefit of indexation. Final Word Both the Arbitrage fund and Liquid funds have their pros and cons. While arbitrage funds score higher in terms of tax efficiency and returns on investment, liquids offer better stability and liquidity. So, the choice of funds should depend on your investment goals.

Arbitrage is the practice of simultaneously buying and selling an asset in different capital markets to profit from a price difference. These funds also invest in debt and money market instruments.As the equity exposure of arbitrage funds is hedged, the price risk tends to be low when investing in these funds. Furthermore, the credit risk is low in arbitrage funds. One of the most important benefits of arbitrage funds is that it offers equity taxation.The tax rate on arbitrage funds is similar to equity funds. You will be charged Short-Term Capital Gains (STCG) tax of 15% if you hold the funds for less than a year. If you hold the funds for more than a year, then your gains will be taxed as per Long-Term Capital Gains (LTCG) tax at 10%.

While fixed deposits (FDs) are one of the most popular investment instruments, there are other options that can also help you earn good returns. One such option is arbitrage funds . Typically, arbitrage funds invest in equities. In case of these funds, the securities are purchased and sold simultaneously in different markets. This is done to take advantage of a stock’s price difference in different markets. Thus, the fund manager will buy equities at a low price from one market and sell them in another market where the price is high. This can help them earn good returns.

Here are some differences between arbitrage funds and FDs-

Returns In case of FDs, you get guaranteed returns. However, the returns from arbitrage funds depend on the markets. Risk FDs tend to be low-risk investment options. But arbitrage funds are riskier than FDs because they invest in equity markets. TDS In case of FDs, TDS is deducted at 10% on the interest amount. However, TDS is levied if the interest is above Rs. 40,000. No TDs is levied on arbitrage funds. Tax The interest on a FD is taxable. In case of an arbitrage fund, there are two types of taxation- short-term capital gains (STCG) tax and long-term capital gains (LTCG) tax.STCG is charged 15% if you withdraw the funds within one year. LTCG is taxed at 10% if you withdraw the funds after 1 year.

While arbitrage funds are a good investment option, there are a few risks of investing in these funds, such as-

• You may not recognize an opportunity in time. Thus, it is important to keep your eyes open and make sure to look at different markets to know the price difference.
• An arbitrage fund's return is based on the difference between prices in different markets. Therefore, if you don’t stick to your strategy when purchasing and selling securities, then you may lose your money.
• Arbitrage funds might carry credit risks because they can invest up to 35% of their assets in debt or money market instruments. Hence, you must check the credit quality of the debt portion before making an investment.

Furthermore, investors need to be aware of the possibility that an arbitrage fund might fail to achieve its goal of generating a profit. Thus, before investing in an arbitrage fund, investors should carefully consider all of the risks and rewards associated with it.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.