Liquid Funds or Arbitrage Funds?
There are many investment options to create a wealth corpus. Arbitrage and Liquid funds, too, qualify as good source of investment to appreciate the capital. In this article, we will read about these two investment options in detail.
What are Arbitrage funds?
Arbitrage funds simply refer to a scenario where investors buy securities at cheaper prices in cash equities market and sell them at higher prices in futures or derivatives market. This means that selling and buying are happening simultaneously. Arbitrage funds take benefit of the emerging opportunities in the market. As per taxation law, these funds must hold a minimum of 65% in equities in order to qualify as Arbitrage fund.
How to identify Arbitrage funds?
There are certain characteristics of arbitrage funds as listed below:
Risk
Trade of Arbitrage funds happen at stock exchanges therefore there is no counter party risk exists here. The buying and selling of shares is taking place in cash and future markets therefore there is no direct exposure to equities.
Returns
Arbitrage Funds are known for giving reasonable returns but only those investors can earn profit who know well about how do arbitrage funds work. The fund manager keeps an eye on price differentials in order to generate alpha. Historically, arbitrage funds have offered returns in the range of 7% to 8% over five years to ten years.
Costs
Arbitrage funds are costly because costs of transactions are high. The fund manager also impose an exit load to discourage investors from exiting. All these factors cause an increase in expense ratio of the fund. A high expense ratio means less real returns for investors.
Investment horizon
Arbitrage funds are suitable for investors having short term to medium term time horizon i.e., 3 years to 5 years. Since these funds levy a heavy exit load, investors should invest in arbitrage funds only when they are ready to stay put for minimum of 6 months.
Tax on gains
The tax treatment of these funds is same as equity funds. Short term capital gains are taxed at the rate of 15% while Long-term capital gains are taxed at the rate of 10% without the indexation.
What are liquid funds?
Liquid funds belong to the class of debt funds. These funds invest in money market instruments like treasury bills, commercial papers, and certificate of deposits etc. These are money market instruments which mean that their average maturity period will be of 91 days.
How to identify liquid funds?
The characteristics of Liquid funds are mentioned below:
Liquid funds provide a high degree of liquidity and safety of the capital to investors because liquid funds invest in high rated debt instruments maturing only in 91 days. Investors invest in these funds in order to meet their short term financial goals.
Since these are fixed income generating funds with portfolio maturity of 3 months, these are not vulnerable to interest rate movements. Therefore, the NAV of these funds do not fluctuate much.
Liquid funds are known to have generated profits in the range of 7% to 9% which is higher than the interest rate on savings account. However, the returns are very sensitive to the funds’ liquidity in the money market and interbank deposits. A high availability in the lower interest rate market pushes the interest rates down and high demand in the longer tenure market also increases the interest rates.
Since liquid funds invest in money market instruments which are highly liquid in nature, these are considered as low risk investment. There is another good reason to choose liquid funds is that these funds do not have a lock –in period.
Short-term capital gains are taxed as per the income slab rate after getting added to your overall income. Long term capital gains attract a tax rate of 20% after indexation. The taxation on liquid funds are same as like any other debt funds.
Which one to choose?
Investors should be aware of the fact that the returns on Arbitrage funds are highly volatile as prices reflect the movements in equity market and futures market. Therefore if an investor want to choose Arbitrage funds then he should go for lump sum investment than SIPs. Liquid funds provide better returns than Arbitrage funds over the same investment horizon. The table which is mentioned below shows 1 year over rolling from the table that returns for 3 years. It could be clearly seen from the table that liquid funds performed better than Arbitrage funds. Table shows that 79% of the time liquid funds were able to generate more than 6.5% returns while arbitrage funds achieved only 33% of time. Arbitrage funds do fluctuate frequently therefore these are not suitable for investors who are having short term financial goals. On the contrary, liquid funds do well in providing liquidity for investors who want to meet their short term financial goals. Liquid funds are safe and generate better returns than Arbitrage funds however arbitrage funds are most suited for those who have the risk appetite and a sound financial expert who can time the exit and entry in equity and futures markets
Over rolling 1-year periods for 3 years
| Fund Type | % times returns > 6% | % times returns > 6.5% |
|---|---|---|
| Liquid funds | 90% | 79% |
| Arbitrage funds | 89% | 33% |
Conclusion
It is to be noted that there is no guarantee of returns on liquid funds but historically these have performed better than arbitrage funds. If investors want to keep a portfolio of equity and debt, then they can keep some of arbitrage funds in their portfolio provided they keep a close watch on the market environment. It looks that trading in arbitrage funds is a smooth process but the faster the opportunities arise the sooner they get disappear therefore a very active approach is required for arbitrage funds. Liquid funds are safe and appreciate your capital with less risk. It is up to investors to choose as per their own financial goals and risk appetite.
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