Arbitrage Funds vs Liquid Funds: Which is Better for Short-Term Investment?

What is an Arbitrage Fund?

Arbitrage funds, categorised under hybrid funds by SEBI, predominantly invest (at least 65%) in equities and equity-related instruments. However, they differ significantly from traditional equity funds due to their unique market-neutral strategy.

Investment Strategy:
The core idea is to exploit the price differential between the cash (spot) and futures markets. Fund managers buy equities in the spot market and sell them in the futures market simultaneously. The locked-in spread, regardless of market direction, generates returns. For instance, if Infosys trades at ₹1,500 in the cash market and ₹1,520 in the futures, the fund buys at ₹1,500 and sells at ₹1,520, locking in a ₹20 gain per share.

Advantages:

• Market-neutral = Reduced directional risk.
• Taxed as equity = Long-term capital gains taxed at 10% after a year.

Beneficial for high-tax bracket investors looking for equity taxation but without equity-style volatility.

Challenges:

• Volatility dependent: Profits are tied to how wide the arbitrage spreads are, which typically widen in volatile markets.
• Higher transaction costs due to active churning.
• Redemption delays are due to the T+2 settlement structure and possible exit loads if withdrawn early.
   

What is a Liquid Fund?

Liquid funds, a sub-category of debt mutual funds, invest in very short-term debt instruments with a maturity of 91 days or less. Examples include Treasury Bills (T-Bills), Commercial Papers (CPs), Certificates of Deposit (CDs), and overnight repos.

Key Features:

• High liquidity: Redemption is processed on a T+1 basis, i.e., investors typically receive money the next working day.
• Minimal interest rate risk due to short maturities.
• Stable NAV with near-zero volatility in returns.
• Ideal for investors with ultra-short investment horizons (from a few days to three months).

Pros:

• Quick access to funds for emergencies.
• Low default risk, especially if investing in AAA-rated instruments or sovereign papers.
• Low expense ratio due to passive portfolio management.

Cons:

• Returns are capped in line with money market rates.
• Interest rate sensitivity is held during sudden rate spikes.
• Tax inefficiency for high-income individuals due to debt-style taxation.
   

Arbitrage Fund vs Liquid Fund: A Detailed Comparison

Taxation Differences

This is perhaps the most critical factor separating the two fund types.

Arbitrage Fund Taxation (Post-2025 Budget):

• Short-Term Capital Gains (STCG): 20% if held for less than 12 months.
• Long-Term Capital Gains (LTCG): 12.5% (above ₹1.25 lakh exemption) if held beyond 1 year.

No indexation benefit.

Liquid Fund Taxation:

• Short-Term (<3 years): Taxed as per the investor’s income tax slab.
• Long-Term (>3 years): No longer eligible for indexation; taxed at applicable slab.

Implication: Arbitrage funds offer superior post-tax returns for investors in the 30 %+ slab if held for even a slightly longer period (~3-6 months), whereas liquid funds become tax-inefficient quickly.
 

Risk and Return Factors

Arbitrage Funds:

• Risk: Low market risk, but it depends on the availability of arbitrage spreads.
• Return: Moderate, typically tracking short-term interest rates but slightly higher than liquid funds in volatile markets.

Default Risk: Very low due to hedging.

Liquid Funds:

• Risk: Almost negligible if invested in high-quality papers.
• Return: Consistent and stable, but may lag during low-interest periods.
• Default Risk: Low but not zero; credit downgrades (e.g., IL&FS) have impacted funds in the past.

Which is Better for Short-Term Investment?

Note: Arbitrage funds outperform only if exit loads are avoided and held beyond the minimum exit period.

Factors to Consider Before Investing

• Tax Bracket: Investors in the 20–30% slab should prefer arbitrage funds for better post-tax returns.
• Time Horizon: Less than 7 days = liquid; 30–90 days = arbitrage.
• Liquidity Needs: Liquid funds offer faster redemption (T+1).
• Market Volatility: Arbitrage performs better in choppy markets.
• Expense Ratios: Liquid funds win on cost-efficiency.
• Exit Loads: Liquid funds usually waive loads after 7 days; arbitrage often imposes loads for up to 30 days.
   

Conclusion

In the debate of arbitrage funds vs liquid funds, there is no one-size-fits-all answer. Investors must weigh tax efficiency, return expectations, liquidity requirements, and costs.

Choose arbitrage funds if you're in the higher tax bracket, don't need immediate liquidity, and can tolerate modest volatility for slightly better post-tax returns.

Choose liquid funds if your focus is capital preservation, instant access to funds, and you're in a lower tax bracket.

Both types serve distinct purposes and can coexist in a portfolio. The optimal strategy might involve allocating a portion to each, based on changing liquidity needs and taxation dynamics.