Arbitrage Funds vs. Liquid Funds vs. Savings Bank A/C: How to Park Your Short-Term Funds - Outside View by PersonalFN

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Arbitrage Funds vs. Liquid Funds vs. Savings Bank A/C: How to Park Your Short-Term Funds
Aug 23, 2016

Robert's list of things to do in one year:

  • Buy new furniture for the house
  • International vacation with family
  • Contingency funds

These are Robert's short term financial goals which he hopes to achieve in the next one year and is planning his finances accordingly. John, Robert's friend who is a financial advisor has given him three options: arbitrage funds, liquid funds, or letting cash idle in his savings account and earn some interest on it.

If like Robert you have goals too, let us understand these three investment options...

Arbitrage Funds:

Arbitrage means simultaneously buying and selling of securities, currency, or commodities in different markets at same time. For example, equities can be traded in cash as well as derivatives market. In the 'cash market' investors buy / sell securities at a price for delivery and settlement of trade. On the other hand, in the 'derivatives market', especially in 'futures', a contract is entered to buy/sell security at some future date with no immediate delivery of the security.

On several occasions, the same asset is traded at different prices in different segments and/or different markets, which results in an arbitrage. This arbitrage opportunity has given birth to arbitrage funds, wherein the fund manager tries to capitalize on such opportunities by exploiting the price differentials. They take opposite positions in different markets / different segments depending on opportunities in order to clock returns. They rarely result in a loss, but mind you, a possibility of a loss cannot be ruled out.

Liquid Funds:

Liquid funds are open-ended mutual funds that primarily invest in money market instruments like Certificate of Deposits (CDs), Commercial Papers, term deposits and treasury bills, where the maturity of debt papers is upto 91 days. They are highly liquid and carry very low risk. Moreover, they do not carry any exit loads and withdrawals can be processed within 24 hours on a business day. Hence, liquid funds are suitable to manage short-term liquidity needs - say when one has an investment horizon of less than 3 months.

Savings Bank Account:

Well, this is an age-old and easiest way to park short-term needs, and even keep aside some money to manage contingencies. You earn around 4% -- 6% p.a. interest depending on the bank you opt for to park your savings

But if you wish to battle inflation (which erodes the purchasing power of your hard earned money) while managing your short-term liquidity, you can't be parking too much surplus in a saving bank account. It will prove to be imprudent.

A prudent comparative assessment of various short-term investment avenues is necessary to park short-term liquidity prudently. Consider this...

A Comparative Study: Arbitrage Funds vs. Liquid Funds vs. Savings Bank A/c
  1 Year (%) 3 Year (%) 5 Year (%)
Category Avg. of Arbitrage Funds 7.07 8.08 8.28
Category Avg. of Liquid Funds 7.78 8.30 8.43
Savings Bank Account 4-6%

Category average has been calculated taking into account the peers
Returns over 1 year are compounded annualized
(Source ACE MF, PersonalFN Research)

Thus far, both, arbitrage and liquid funds have generated superior returns compared to the interest earned on a savings bank account which is around 4% -- 6% p.a. Though the Reserve Bank of India (RBI) de-regulated bank rates in 2011, very few banks offer interest @ 6% p.a.

Moreover, from a tax perspective since arbitrage funds are treated as equity oriented, whereby dividends and long term capital gains tax (for units held for more than 12 months) are tax free. Also, the short term capital gains are taxed at 15% (for units held for a period of less than 12 months). So, they offer liquidity plus are capable of generating tax-efficient returns by managing the high volatility of the market.

While, liquid funds too are a good option to park your idle cash and relatively less risky; the debt-oriented classification puts them in a disadvantageous position. The Long Term Capital Gains (LTCG) tax (for units held for more than 36 months) @ 20% with indexation benefit is restraining. Additionally, if opted for the dividend option, the dividend declared by liquid funds carry effectively 28.84% Dividend Distribution Tax (including surcharge and cess). There is no scope for a tax arbitrage, which was possible before the Union budget 2014-15.

In case of savings bank account, the interest is not subject to Tax Deduction at Source (TDS), but the interest over a sum of Rs 10,000 is taxable as per the provisions of section 80TTA of the Income-tax Act, 1961. Thus if you keep excess liquidity in a savings bank account and fall in the highest tax bracket of 30%, you could be at a disadvantage.

PersonalFN believes, before parking your savings in any of these avenues assess your immediate liquidity needs and then prudently allocate the investible surplus to a savings bank account, liquid fund, and arbitrage fund gauging your risk appetite. This will help you generate optimum returns while addressing short-term liquidity needs. If you let your surplus liquidity lie in a savings bank account, you will lose out on the opportunity to clock potential returns.

Mr. Robert should take note of this while managing liquidity needs and deploying the investible surplus productively to accomplish short-term as well as long-term investment objectives / financial goals prudently.

Prudent investing and financial discipline are vital ingredients for long-term financial wellbeing.

PersonalFN is a Mumbai based personal finance firm offering Financial Planning and Mutual Fund Research services.

Disclaimer:

The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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