Arbitrage Fund vs Liquid Fund

Choosing the right investment option for the short term may not be as easy as you think. The plethora of options available can make an already daunting task even more challenging. However, if you’re looking to park your idle funds for the short term and earn moderate returns, arbitrage funds and liquid funds are two attractive investment options you can consider. 

Both of these types of mutual funds have their own unique characteristics and cater to different kinds of investors. In this article, we’ll explore the various nuances of each of these two funds and delve into the various differences between an arbitrage fund and a liquid fund to determine which is a better option for short-term investments.

What is an Arbitrage Fund? 

An arbitrage fund is a type of equity mutual fund that invests a minimum of 65% of its portfolio in equity and equity-related instruments. The fund follows an arbitrage strategy that aims to exploit price differentials in different markets or securities. It usually buys securities in one market and simultaneously sells them in another market to profit from the difference in price between the two. 

Here is a hypothetical example of how an arbitrage fund works. 

An arbitrage fund purchases a particular quantity of stock in the cash market. Simultaneously, it sells the same quantity of stock in the futures market at a slightly higher price. Now, irrespective of how the market moves, the price differential between the two markets is essentially locked in. The fund will hold the futures contract until the expiration date and close both the futures and cash positions at the same price. This locked-in price differential is the return generated by the fund. 

Key Features of an Arbitrage Fund 

Arbitrage funds have several key features that distinguish them from other types of equity mutual funds. Let’s look at a few of them. 

• Market-Neutral Strategy

Arbitrage funds employ a market-neutral strategy by simultaneously buying and selling assets in different markets to capitalise on price differentials. This strategy helps mitigate market risk since the fund’s returns are not dependent on the direction of the market.

• Lower Risk Profile

Compared to other types of equity funds, arbitrage funds generally have a lower risk profile. This is because they capitalise on arbitrage opportunities that arise due to market inefficiencies rather than relying solely on market movements for returns. 

• Moderate and Stable Returns

Although the returns from arbitrage funds may not be as high as those of pure equity funds during bull markets, they tend to be less volatile and more consistent over the short to medium term. 

What is a Liquid Fund? 

A liquid fund is a type of debt mutual fund that invests in short-term debt and money market instruments with maturity periods of up to 91 days. Some of the assets that the fund invests in include Treasury Bills (T-Bills), commercial papers (CPs), certificates of deposit (CDs) and short-term government securities. 

The primary objectives of liquid funds are capital preservation and liquidity. These funds offer a high degree of liquidity, allowing investors to park their surplus funds for short durations while earning returns that are typically higher than traditional investment options. 

Key Features of a Liquid Fund 

Before we check out the comparison of an arbitrage fund vs. a liquid fund, let’s quickly glance through the key features of liquid funds. 

• High Liquidity

Liquid funds are known for their high liquidity, allowing you to redeem your investments quickly and easily. Additionally, since the securities that these funds invest in have no lock-in period, you can liquidate your holdings freely without any penalties. 

• Capital Preservation

The primary objective of liquid funds is capital preservation. The funds achieve this by investing in high-quality and low-risk debt and money market instruments. 

• Low Volatility

Since liquid funds invest in debt and money market instruments with short maturities of up to 91 days, they are not very susceptible to market volatility. 

Arbitrage Fund vs. Liquid Fund: The Differences 

Understanding the differences between an arbitrage fund and a liquid fund is crucial since it can help you easily determine which one’s right for you. Here is a table outlining the key points of distinction. 

Liquid Fund or Arbitrage Fund: Which is a Better Short-Term Investment Option?

Now that you’ve seen the tabulated comparison of an arbitrage fund vs. a liquid fund, let us look at which of the two is the better option. 

Arbitrage funds may be a suitable option for you if you’re looking for equity market exposure with the potential for stable returns and lower risk. However, it is essential to note that there are certain inherent risks associated with arbitrage transactions. Also, there’s the possibility of the fund generating lower returns due to volatile market conditions. 

Liquid funds, on the other hand, may be suitable for you if you are seeking liquidity, safety and moderate returns over a short investment horizon. These funds are ideal for parking surplus cash, such as emergency funds or funds earmarked for upcoming expenses, for short durations.

Ultimately, when it comes to short-term investment options, both arbitrage funds and liquid funds have their merits. The choice between the two depends on factors such as your preference, risk tolerance, investment horizon and financial goals. 

That said, you could also consider investing in both of these options to diversify your portfolio. This way, you would be spreading your investment risk over both equity and debt, potentially reducing the negative impact on your portfolio due to adverse market movements.

Conclusion

Despite the differences between arbitrage funds and liquid funds, they are both attractive short-term investment options. Irrespective of the option you choose, remember to consider the various benefits and risks involved with each of these funds before investing in them. 

Also, make sure to take into account factors such as the expense ratio, the fund manager’s expertise and past performance metrics of the funds. This way, you can ensure that you make a well-informed decision that is in line with your financial goals and objectives. 

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