{"id":15233,"date":"2019-05-29T12:22:14","date_gmt":"2019-05-29T06:52:14","guid":{"rendered":"https:\/\/www.fundsindia.com\/blog\/?p=15233"},"modified":"2019-11-07T13:51:31","modified_gmt":"2019-11-07T08:21:31","slug":"fundsindia-strategies-liquid-or-arbitrage-funds-for-short-term-money","status":"publish","type":"post","link":"https:\/\/fundsindia.com\/blog\/mf-research\/fundsindia-strategies-liquid-or-arbitrage-funds-for-short-term-money\/15233","title":{"rendered":"FundsIndia Strategies: Liquid or Arbitrage funds for short-term money?"},"content":{"rendered":"

When you look at low-risk options for parking short-term money, liquid funds are often opted for. But the tax-conscious amongst you often ask us if you should go for arbitrage funds instead since they are taxed at lower rates. Here, we stack up the pros and cons of the liquid and arbitrage funds and tell you how to decide what\u2019s suitable for you.<\/span><\/p>\n

What do the funds do?<\/b><\/p>\n

These two categories of funds are very different in what they do. For starters, liquid funds hold debt instruments while arbitrage funds invest in equity.<\/span><\/p>\n

Liquid funds aim to generate returns by accruing interest from underlying papers. They invest only in very short-term high-quality papers. Therefore, they have a very low credit risk and interest rate risk. Their holdings don\u2019t see price volatility and this makes liquid fund returns stable. Barring exceptional circumstances, they don\u2019t suffer losses even on a daily basis. This makes them an ideal option for temporarily investing surplus money. <\/span><\/p>\n

Unlike other equity funds<\/a>, arbitrage funds are low-risk because of their strategy. Arbitrage, as a strategy, aims at taking advantage of mispricing between the cash and the futures market. Arbitrage funds hedge their entire stock holdings. Essentially, there is no market risk despite investing in equity. However, because of this hedging, they also don\u2019t enjoy equity-like returns.<\/span><\/p>\n

The question of whether arbitrage or liquid funds are better options for short-term investments involves understanding three aspects \u2013 returns, risk, and taxes.<\/span><\/p>\n

Invest Now! <\/span><\/a><\/div>\n

Comparing returns<\/b><\/p>\n

The usual holding time frame for liquid funds is around 3 months or less. We used these time frames and the average returns of both the categories to understand how returns pan out. Here\u2019s what we found.<\/span><\/p>\n\"\"<\/a>\n

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  1. There is no distinct trend in returns:<\/span><\/i><\/li>\n<\/ol>\n

    Liquid funds move in line with interest rate cycles while arbitrage funds look for mispricing opportunities. While both categories have different factors affecting their returns, there is no clear correlation between stock market cycles and arbitrage fund performance. At best, arbitrage does well at market cycle inflexion points or in flattish markets. <\/span><\/p>\n

    \u00a0 \u00a02.\u00a0<\/span>Liquid funds, on an average, have returned better: <\/span>\u00a0<\/span><\/i><\/p>\n

    In the past 10 years, liquid funds gave higher returns than arbitrage funds 80% of the time if we consider 3-month and 1-month periods. Lack of arbitrage opportunities, smaller gains from hedging activity, and relatively higher expense ratios could be reasons pulling down arbitrage returns compared to liquid funds. The differential in returns is not high \u2013 it has averaged 0.16 percentage points in the 3-month rolling returns. <\/span><\/p>\n

    Risk <\/b><\/p>\n

    The risk that you would like to avoid with these funds is volatility. When you park funds for a period ranging from a few days to a few months, you can\u2019t wait for funds to recover from any short-term falls. This is why it is important to look at how the funds contain downsides. <\/span><\/p>\n

    We looked at the last 5-year period, ignoring any losses arising from the IL&FS debt crisis. On a monthly basis, both categories fared well with only one arbitrage fund seeing a marginal loss. But on a daily basis, there is a huge difference in volatility. <\/span>Liquid funds hardly saw one-day losses with 2 or 3 exceptional instances while arbitrage funds suffered one-day losses around 30% of the time. \u00a0\u00a0\u00a0<\/b><\/p>\n

    Post-tax returns<\/b><\/p>\n

    Now that we have discussed risk and return aspects, we\u2019ll move on to what\u2019s important – what are the post-tax returns you will realise.<\/span><\/p>\n\"\"<\/a>\n

    Returns are absolute and post-tax<\/span><\/i><\/p>\n

    Since these funds are held for less than a year, short-term capital gains tax becomes more relevant. Debt funds<\/a> are taxed at your income tax slab rate and equity funds are taxed at flat 15%. With liquid funds generally outpacing arbitrage funds in terms of returns, it is only the taxation that makes a difference.<\/span><\/p>\n