Liquid Funds vs Arbitrage Funds – Which of These Works Best for You
Arbitrage Funds, on account of their superior tax efficiency when compared to liquid mutual funds, gained quite a bit of popularity after the Union Budget 2014. It was during this budget that the minimum holding period for all debt oriented mutual fund investments to qualify for long-term capital gains was increased from 1 year to 3 years. However, Arbitrage Fund returns have taken a beating of late, and recent annualized returns have barely exceeded 5.5% to 6%. The recent Union Budget dealt a further blow to Arbitrage Funds, as their profits will now attract a tax rate of 10% even after a year-long holding period (subject to the total LTCG amount booked in a fiscal crossing Rs. 1 Lakh). Thus, we may now see renewed levels of interest in liquid mutual funds. If you’re confused about which of these two options works best for you to park your short-term moneys, read on.
Minimum Time Horizon
The first question you need to ask yourself is – just how long you’re planning to park your funds in a liquid mutual fund or an arbitrage fund. While Liquid Funds are suitable for investments time frames as short as a few days to a few weeks, arbitrage funds are recommended for investment time frames exceeding at least 3 months, and preferably 6 months. In time frames shorter than these, you’re likely to witness erratic returns from your arbitrage funds, as their overall performance would hinge heavily on the availability of arbitrage opportunities in the market.
Short Term Capital Gains from liquid funds will be clubbed with your income and taxed accordingly. Resultantly, liquid funds become tax efficient for non-earning people, and relatively tax inefficient for those who fall in the highest marginal tax bracket. Thus, your tax bracket should play a key role in determining your decision of which one of these two types of funds to invest into. Short Term capital gains from arbitrage funds attract a flat tax of 15%, so it would make sense for a high-income earner who has a 6-12-month time horizon to invest into such a fund. Similarly, a retiree with no other source of income who is looking to park short term moneys, should ideally do so in a liquid mutual fund.
Although both liquid funds and arbitrage funds are low risk in nature, the latter is more high risk in the sense that its returns can be more erratic. While liquid funds pretty much deliver stable returns that are similar to FD returns, arbitrage funds do a lot better in bullish or range-bound markets, during which such opportunities to capitalise on stock/futures price differentials actually more plentifully. If you are more content taking a lower risk, while sacrificing a potential incremental return of 0.5% to 0.75% in the process, go for liquid mutual funds over arbitrage funds.