Investing in the financial world can sometimes feel like a daunting task, especially for those unfamiliar with its intricacies. Two commonly discussed investment options are arbitrage funds and liquid funds. But what exactly are these funds, and how do they differ? Let’s break it down in simple terms to help you navigate these waters.
Liquid Funds: The Bedrock of Stability
Imagine a pool where you can easily dip in and out whenever you need it. That’s the essence of liquid funds. These funds primarily invest in short-term securities like treasury bills, commercial papers, and certificates of deposit, ensuring high liquidity. They are a haven for investors seeking stability and quick access to their money.
To understand it better, liquid funds are a type of debt mutual fund schemes which invest in debt or money market instruments that mature within 91 days. Liquid funds are money market mutual fund schemes in which you can park your surplus funds for a few days to a few months. These funds don’t charge any fees when you enter or but charge a small fee when you exit within 6 days, making it easy to manage your cash by allowing you to come in and go out whenever you prefer. Liquid Funds are suitable for short-term goals or emergency funds.
Arbitrage Funds: The Art of Making Gains
Although, arbitrage funds fulfill the same purpose of liquidity but follows a different strategy. They aim to leverage price differences in different markets or segments. This is done by simultaneously buying and selling securities in two different markets to exploit the price differential, thereby generating returns. It’s like finding a bargain deal in one market and selling it at a higher price in another.
Arbitrage funds diversify their investments into both debt and equity, and aim to generate returns through arbitrage opportunities in the cash and futures market while consistently hedging their positions. For instance, if an asset is valued at Rs. 15 in market A and Rs. 20 in market B, buying the asset from market A and selling it in market B can result in a profit of Rs. 5.
Since arbitrage funds invest in both debt and equities, it falls under the category of hybrid funds. As per SEBI (regulator of Mutual funds) mandate arbitrage funds must invest at least 65% of their assets (corpus/money) in to equities or equity-related securities. Arbitrage Funds are better suited for investors who have investment horizons of over one-month.
Key Differences
Objective
Liquid Funds: As the 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 (T stands for transaction day) or the next working day, provided the transaction is received before the cut-off time.
Arbitrage funds: In comparison to liquid funds, redemption occurs on a T+2 basis.
Risk and Returns
Liquid Funds: Generally lower risk but offer modest returns. Liquid funds invest in less risky debt instruments, which leads to more stable and consistent returns compared to stocks.
Arbitrage Funds:Low risk with potential for higher post tax returns than liquid funds. Arbitrage funds invest in equities that typically offer higher returns, they do so in a less risky manner. Despite investing a larger chunk in equity instruments, these funds have minimal investment risk because they hedge risks by buying and selling instruments quickly.
Taxation
Liquid Funds: As per SEBI’s classification, liquid funds fall under debt funds, and their returns are included in the investor’s taxable income for the financial year. Regardless of your investment duration, taxes are levied based on the applicable tax rates for your total earnings in a financial year.
Arbitrage Funds: Arbitrage funds, on the other hand, are taxed similarly to equity funds. Short-term capital gains (STCG) from holding funds for less than a year are taxed at 15%, while long-term capital gains (LTCG) are applicable for holdings over a year. If the gains exceed Rs. 1 lakh, a 10% tax rate is applied.
Exit Load
Liquid fund: Liquid funds do not charge any entry load or and have a graded exit load up to six days and no exit load from 7th day.
Arbitrage Funds: Exiting from Arbitrage funds will incur a charge which would be ranging from 0.25% to 0.5%. These fees are applicable if you decide to exit within one month.
Returns
According to Value Research, a mutual fund research firm, in the liquid fund category the highest return was delivered by Bank of India Liquid Fund-Regular Plan (7% average returns) in the last one year, while the highest return in the arbitrage category was delivered by SBI Arbitrage Opportunities-Regular Plan (7.59% average returns) during the same period.
Conclusion
In essence, both liquid and arbitrage funds serve the same purposes in an investor’s portfolio. While both Arbitrage and Liquid Funds carry low risk levels, the favorable taxation on Arbitrage funds makes them more attractive than liquid funds.
Understanding these differences can assist you in making informed decisions about where to allocate your funds based on your financial goals and risk tolerance. Always consult with a financial advisor or conduct thorough research before making any investment decisions. Remember, the key is not just investing but investing wisely in alignment with your objectives.
