Arbitrage fund Vs Liquid Funds (2023): Which alternative is better?

Many people compare Arbitrage Funds with Liquid Funds while picking funds to park money for the short term. But given the differences in arbitrage funds Vs liquid funds, does it make sense to compare the two?

Let’s discuss Arbitrage Vs Liquid Fund.

What is an Arbitrage fund?

Arbitrage Fund belongs to a special category of mutual funds, i.e. Hybrid Funds. These funds work on the principle of profiting from arbitrage opportunities in two different markets. In this case, cash and the derivative segment of the equity markets.

Arbitrage literally means a riskless profit. But in reality, nothing is risk-free. So here, let’s say it applies to low-risk strategies of generating marginal returns using arbitrage opportunities.

Suppose an arbitrage fund purchases shares of a Company XYZ at Rs 1000 per share. Simultaneously it sells it in derivatives or futures market at Rs 1010 per share. Since both transactions happen almost simultaneously, the fund generates a profit of Rs 10 via arbitrage. This is a very simple depiction of the working of the arbitrage fund. The idea is simple. To regularly generate small gains via entering into simultaneous trades (buy/sell), to take advantage of the price variation (spreads) between two different markets.

Interestingly, these funds need to hold at least 65% in equities (including derivatives) in order to qualify as equity funds for tax purposes. So even though these are hybrid funds, these are treated as equity funds for taxation purposes. And that is what makes them attractive. We will discuss this aspect shortly.

What is a Liquid fund?

Liquid funds are one of the least risky categories of debt funds that can only invest in securities with a residual maturity of 91 days or less. The funds make investments mostly in treasury bills, corporate deposits, money market instruments, etc. Generally, liquid funds are known to deliver higher returns than a regular savings account or your short-term fixed deposits.

I have written in detail about this category at How to pick Liquid Funds? And if you want, you can even read the comparison of Overnight Fund vs Liquid Funds.

So what are the differences between the two?

Let’s see:

Risk (Arbitrage Vs Liquid Funds) – Liquid funds are much safer than arbitrage funds. A liquid fund invests in debt instruments with a short maturity period (91 days). An arbitrage fund invests in atleast 65% equity and relies on arbitrage opportunities to generate returns. And since the spot and futures positions of arbitrage funds are marked-to-market on a daily basis, there may be periods when arbitrage funds experience a drop in their NAV. Also like we have seen in the recent debt fund crisis in 2020, the debt portion of the arbitrage fund (up to 35% of the AUM) too may see a drop in valuation in case of downgrades or adverse interest rate changes.

Returns (Arbitrage Vs Liquid Funds) – Both fund types have similar return profiles and at times are seen as an alternative to the savings account and also as a viable alternative to bank fixed deposits. But given the potential of arbitrage opportunities in equity markets, at times arbitrage funds can deliver much higher returns. But having said that, arbitrage funds can also fluctuate a lot on a daily basis. They at times can deliver negative monthly returns as well.

Here are the best and worst return profiles of two of the largest liquid fund and arbitrage funds in India (as of 16 Jan 2022).

SBI Liquid Fund (Direct Plan) – AUM of Rs 71,000 Crore +

Kotak Equity Arbitrage Fund (Direct Plan) – AUM of Rs 24,000 Crore +

As you can see, arbitrage funds can have poor runs in the short term (weekly or monthly).

And if we compare the annual returns for both fund categories, we see the liquid fund as a category that has done better. For the last several years:

But pre-tax returns are not what wins it for arbitrage funds.

It’s the post-tax returns.

Taxation (Arbitrage Vs Liquid Funds) –

For Liquid Funds (read debt fund taxation):

• Short Term Capital Gains (STCG) – If gains are made in liquid funds held for less than 3 years (or 36 months), then it is taxed as per the investor’s income tax slab rate.
• Long Term Capital Gains (LTCG) – If gains are made in liquid funds held for more than 3 years (or 36 months), then it is taxed at 20% with indexation

For Arbitrage Funds (are treated as Equity funds for taxation purposes):

• Short Term Capital Gains (STCG) – If gains are made in arbitrage funds held for less than 1 year (or 12 months), then it is taxed at 15%
• Long Term Capital Gains (LTCG) – If gains are made in arbitrage funds held for more than 1 year (or 12 months), then it is taxed at 10% for gains above Rs 1 lakh a year.

Arbitrage funds can be more tax-efficient than liquid funds based on your tax bracket. If you are in the 20-30% tax slab, then the average returns of both categories suggest that arbitrage funds deliver superior post-tax returns for periods above 1-2 years.

Let’s say the 1-year pre-tax return for both the arbitrage fund and the liquid fund is 6%. Now assuming a period slightly higher than 1 year, the applicable tax rate in the case of arbitrage fund will be 10%, hence the post-tax returns will be 5.4%. But in the case of liquid funds, the applicable tax rate will be as per the slab of the investor. So in the case of the 5% tax slab, the post-tax returns will be 5.7%. In the case of 20% slab, it will be 4.8% and in the case of 30% slab, it will be 4.2%. So for higher tax slabs, arbitrage funds deliver better post-tax returns.

But even though arbitrage funds are tax-friendly, they are still volatile. And hence, may not be suitable for everyone and those who want to invest for the very short term. I would say that if you have to invest in arbitrage funds, you should be willing to stick around for 1 or more years. Anything less and it may not work in your favor when compared to liquid funds (or even ultra-short duration funds, money market funds).

Related Reading – Taxation of Arbitrage Funds in India

Liquidity (Arbitrage Vs Liquid Funds) – Liquidity in the case of liquid funds is better. You get your money back in 1-2 days. A part of it is also available instantly under the instant redemption facility of some liquid funds. But it might take 3-5 days to withdraw money from an arbitrage fund. So this factor should be kept in mind.

Also, there are no exit loads in liquid funds after 7 days. These have graded exit loads for the first few days. Arbitrage funds on the other hand have exit loads for a period of about a month (30 days).

Now there is one more important factor to understand about arbitrage funds.

What happens when there is a Lack of Arbitrage Opportunities for Arbitrage Funds?

Due to the very nature of arbitrage opportunities, it’s a fact that if more players enter the space, then the extent of arbitrage (or the opportunity itself) will reduce. This is what happened in mid-2020 when many AMCs shuttered fresh investments in their arbitrage funds stating a lack of arbitrage opportunities. This is a problem with the arbitrage approach to investments. If more players enter the space, the increase in the pool of money running after the opportunity can be a showstopper for the category as a whole. This is because it will remove/reduce the arbitrage opportunities that were easily available earlier when space was smaller.

Also, around the crazy month of March 2020, the average arbitrage spreads had turned negative for the first time in a decade. A fall in spread makes return generation difficult, at least in the near term. So when such events play out, howsoever rarely, the arbitrage funds end up earning lower returns than other debt fund categories. Even the inherent tax advantage doesn’t help them then as the before-tax returns are so low.

So that is about Arbitrage Funds vs Liquid Funds (2023) in India.

I don’t like questions like Are Arbitrage Funds Better Than Liquid Funds? Because both arbitrage funds and liquid funds have their pros and cons. So while arbitrage funds are known to do better on tax efficiency and return front, it’s the liquid funds that offer more stability and liquidity. So should you then consider arbitrage funds as an alternative to liquid funds to park short-term funds? This will depend on your requirements, product suitability, and your tax slab.

I hope you found this comparison of Liquid Fund Vs Arbitrage Fund (2023) in India useful and you are now in a better position to make the decision about whether Is Arbitrage Fund a better alternative for Liquid Funds?