When investing your hard-earned money, making informed decisions that align with your financial goals is crucial. Two popular investment options for Indian investors are arbitrage funds and liquid funds. While both have their merits, understanding the differences and benefits of each can help you make an informed choice.

What are arbitrage funds?

Arbitrage funds are a type of equity-oriented mutual fund that aims to take advantage of price differentials in the cash and derivatives markets. These funds generate returns by buying stocks in the cash market and selling equivalent futures contracts. The returns generated from arbitrage funds are relatively consistent and independent of market movements. 

Key features of arbitrage funds:

Lower risk: Arbitrage funds carry lower risk than equity funds as they focus on price differentials rather than market movements. They provide investors with a cushion against market volatility.

Tax efficiency: Arbitrage funds are treated as equity funds for tax purposes, making them eligible for long-term capital gains tax benefits. If held for over a year, gains up to Rs 1 lakh are tax-exempt.

Moderate returns: While arbitrage funds offer stable returns, they are typically lower than equity funds. However, they still outperform traditional fixed-income instruments like fixed deposits.

What is a liquid fund?

Liquid funds, also known as money market funds, are debt mutual funds that invest in short-term money market instruments with maturities of up to 91 days. These funds offer high liquidity and are ideal for parking surplus funds or short-term investment needs.

Key features of liquid funds:

Liquidity: Liquid funds provide quick access to your invested capital, allowing you to withdraw your money within 24 hours. This feature makes them suitable for emergency funds or short-term goals.

Low risk: Liquid funds primarily invest in highly liquid and low-risk debt instruments such as treasury bills, commercial papers, and certificates of deposit. The risk associated with liquid funds is relatively low compared to other investment options.

Stable returns: While liquid funds aim to provide stable returns, they are typically lower than equity-oriented funds. However, they offer higher returns than traditional savings accounts or fixed deposits.

Difference between arbitrage funds and liquid funds

  Arbitrage Funds Liquid Funds
Investment Strategy Simultaneously buying securities in the cash market and selling equivalent futures contracts. Invest in short-term money market instruments such as treasury bills, commercial papers, and certificates of deposit.
Risk Profile Lower risk compared to equity funds. Focus on price differentials rather than market movements. Primarily invest in short-term debt instruments with high credit ratings. Relatively low risk compared to equity-oriented funds.
Taxation Treated as equity funds for taxation. Gains up to Rs 1 lakh held for over a year are tax-exempt. Gains above that threshold are taxed at 10%. Treated as debt funds for taxation. If held for less than three years, subject to short-term capital gains tax as per the individual’s income tax slab. If held for over three years, subject to long-term capital gains tax of 20% with indexation benefits.
Return Potential Moderate returns are relatively consistent and independent of market movements. Stable returns, generally lower than equity-oriented funds.
Liquidity Moderate liquidity. Investors can redeem investments within a certain time frame. High liquidity. Investors can redeem investments within 24 hours.

To wrap up

Considering these differences and aligning them with your investment goals, risk tolerance, and liquidity requirements is essential when choosing between arbitrage funds and liquid funds. Diversifying your portfolio across different asset classes can also help achieve a balanced and optimized mutual fund investment strategy.