Arbitrage Funds vs. Liquid Funds: Which one is right for you?
What are liquid funds?
Liquid funds are debt mutual funds that invest in ultra-short-term instruments—such as commercial papers, treasury bills, and certificates of deposit—with maturities up to 91 days. They aim to preserve capital while offering slightly higher returns than a savings account. With redemptions settled by the next business day (T+1), they're ideal for parking surplus cash safely.
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These funds come with no lock-in period or exit load, offering the highest liquidity among all mutual fund categories. Investors can redeem their units and receive the proceeds within a single business day.
What are arbitrage funds?
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Arbitrage funds fall under the hybrid category, typically allocating at least 65% to equity or equity-related instruments. These funds profit from price mismatches between the cash and futures markets, taking simultaneous buy-sell positions and locking in the spread. Since the equity exposure is hedged, they maintain a market-neutral stance, offering returns similar to debt funds but often with equity-tax treatment.
For example, if an asset is available for Rs 100 in one market segment and Rs 110 in another, the fund simultaneously buys at the lower price and sells at the higher one, locking in a Rs 10 profit. Although arbitrage funds are classified as equity funds, they are considered very safe because their positions are fully hedged.
Key differences
Feature
Liquid funds
Arbitrage funds
Category
Debt
Hybrid
Liquidity
T+1 settlement, very quick access
Usually T+2/3, slightly longer
Risk Level
Very low, carries credit risk and interest rate risk
No risk, 100% hedged
Returns
Stable but modest
Moderate
Taxation
Added to income and taxed at applicable slab rate
12.5% LTCG tax after one year
Exit Load
None after 7 days
May apply if redeemed within 30–90 days
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Which one should you choose?
Choose liquid funds if:
You need very high liquidity (withdraw anytime with next-day credit).
You want a very safe place to park funds temporarily.
You are investing for a very short period (few days to weeks).
You are in a lower tax bracket, where debt taxation is not a big concern.
Choose arbitrage funds if:
You can invest for 3 months or more and don't need instant access to funds.
You are in a higher tax bracket and can benefit from equity taxation.
You want relatively low volatility but potentially higher post-tax returns.
You're looking for an alternative to short-term debt funds with added tax benefits.
Both liquid and arbitrage funds serve as safer alternatives to bank deposits. If immediate access is your priority, go with liquid funds. But if you're seeking optimised returns with tax efficiency, and can tolerate a bit of complexity, arbitrage funds may offer the edge.
Understanding your investment horizon, liquidity needs, and risk tolerance is essential before choosing.
(
Disclaimer
: Recommendations, suggestions, views and opinions given by the experts are their own. These do not represent the views of Economic Times)
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