Are arbitrage funds really better than liquid funds?There are many investors who have of late received WhatsApp messages on how arbitrage funds are doing better than liquid funds. One of the arbitrage funds has apparently gained 8% in one month; whenever you see such messages always check the facts. Are arbitrage funds really better than liquid funds? Let us bring both sides of the story and then you can decide.

Arbitrage funds

Arbitrage funds use arbitrage positions to make money. What is arbitrage? It is the simultaneous buying and selling of securities in order to take advantage of differing prices for the same asset. Arbitrage funds aim to generate low volatility returns by using arbitrage and other derivative strategies in equity markets and investments in short-term debt portfolio. It is marketed as a short term income generation solution.

What makes it special? Arbitrage fund is a type of equity fund, it enjoys tax benefits like an equity fund, even though its returns are similar to debt funds. So, gains in arbitrage funds are taxed at 10% (plus surcharge) if held for more than 1 year since they qualify as long term capital gain. Short term capital gains (STCG) tax is at 15% of gains (plus surcharge, if applicable and cess) if units are held for less than 12 months.

Performance comparison

Fund category 1-week 1-month 3-month 1-year 3-year 5-year 10-year
Hybrid: Arbitrage 0.04 0.5 1.18 5.69 6.1 6.96 7.12
Debt: Liquid 0.13 0.3 1.44 6.64 6.94 7.71 7.7
Data as on Oct 12, 2018

Liquid funds

Liquid Funds are debt mutual funds. They invest money in short term market instruments like treasury bills, government securities, and corporate bonds. These funds can invest in instruments with maturity of up to 91 days.

In case of debt funds, including liquid schemes, one has to hold the investments for 36 months to qualify for long term capital gains. Long term capital gains (LTCG) tax is at 20% (plus surcharge, if applicable and cess) with indexation if units held for more than 36 months. Indexation reduces the actual tax rate at much lower than 20%. Short term capital gains (STCG) tax at the income tax slab rate if units are held for less than 36 months.

Differences between two fund categories

You need to know the differences between arbitrage and liquid funds, which will help you understand if arbitrage funds are an alternative to liquid funds or not.

Firstly, the liquidity of a liquid fund is far better than arbitrage fund. It takes 3 to 5 days to redeem an arbitrage fund, in contrast a liquid fund can be redeemed in a day.

Secondly, the post tax return on investment for an arbitrage fund will be slightly better than post tax return on a liquid fund even if pre tax returns are same. This is why many investors want to park the money in arbitrage funds, even though they are a slightly higher risk than liquid funds.

Thirdly, extensive market research is required in case of arbitrage fund managers. Spotting and profiting from arbitrage funds is no child’s play. A liquid fund is not so much complicated.

Fourthly, exit penalties: Liquid funds don’t have exit penalties, but arbitrage funds attract premature withdrawal penalty, usually 0.25-1.0%.

Arbitrage for risk-averse?

Many fund managers go on television channels and social media platforms claiming arbitrage funds are the best fit for a risk-averse investor. But, is it true? Not necessarily.

Returns in arbitrage funds for short time periods can be negative as well. For instance, Principal Arbitrage Fund has lost 3.9% value in last one month. Losses are a huge blow for risk-averse investors.

On an average, arbitrage funds have given between 5-6% gains in last one year. This is comparable to 5-7% gains locked by liquid funds.

The argument in favour of arbitrage funds is tax efficiency over debt funds. When debt fund returns drop, the buzz around arbitrage funds rises. However, do note that after the imposition of LTCG on equity funds, the tax advantage enjoyed by arbitrage funds is relatively lower now.

But the performance of liquid funds is more stable than arbitrage funds. Plus, you can exit liquid funds anytime with no cost, something which is missing in arbitrage funds. We at RupeeIQ strongly believe that tax advantage should not the guiding factor behind investments.