Mutual funds are suitable for all types of investors. If you have a relatively high-risk appetite and want to build a long-term corpus, you can invest in equity mutual funds. But if you’re a risk-averse investor looking to invest for the short-term, you can opt for liquid funds.
Liquid funds are primarily debt-based mutual funds that allow investment for a very short period of up to seven days. However, they have not been able to deliver optimal returns for the last two years due to unstable market conditions. As a result, many investors have started looking for a substitute of liquid funds to park their money for short periods.
The rise of Arbitrage Funds
Arbitrage funds help investors keep their investments safe from short-term market volatility. Arbitrage funds are equity-based mutual funds that focus on generating returns by using the concept of arbitrage for equity markets.
Many people believe that arbitrage funds can be a good substitute for liquid funds. But is this true? Let’s evaluate both viewpoints and determine whether arbitrage funds can be a better alternative to liquid funds or not.
What are arbitrage funds?
Arbitrage funds are hybrid mutual funds that invest mainly in equities and leverage arbitrage opportunities in the market to protect the investments from short-term volatility. In other words, they generate income from differences in the pricing of cash and futures between the two markets.
For instance, the pricing of cash and futures of the same product may differ in different markets. The fund manager of an arbitrage fund uses this difference in pricing to generate income by selling and buying stocks at the same time.
Are arbitrage funds a better alternative to liquid funds?
To determine whether arbitrage funds can serve as an alternative to liquid funds, let’s first understand the differences between the two:
- Liquid funds can be encashed within 24 hours, whereas an arbitrage fund may take three to five days for redemption.
- Investments in liquid funds can be made only as lump sums, whereas investments in arbitrage funds can be made through lump sums as well as SIPs.
- Arbitrage funds tend to perform better than liquid funds when the markets are volatile.
- Unlike liquid funds, arbitrage funds are equity-based, and hence, they carry more risks.
- The investment horizon for liquid funds can be as low as a day or a week, whereas the ideal investment horizon for arbitrage funds is at least three months.
- Asset Management Companies (AMCs) do not charge any exit load on liquid funds. However, an exit load of 0.25 to 0.5 percent is applicable on premature withdrawal of arbitrage funds.
- Returns generated from liquid funds are taxed as per the short-term capital gains (STCG) taxation rules. On the other hand, returns from arbitrage funds are taxed as per the duration for which they are held.
As you can see, there are a lot of differences between liquid funds and arbitrage funds. While liquid funds are meant for investors with a very short investment horizon (up to 7 days), arbitrage funds are more suitable for investors with a bit longer investment horizon of six months to one year. Both are prudent investment instruments, but they cannot be a substitute for each other.
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