Arbitrage funds vs liquid funds – which one to invest in?

Whatsapp share
Tweet it out
Share on FB
Post on LinkedIn

From the questions we receive from you, it seems to us that many of you are keen to use arbitrage funds. However, it is really important for you to first know what goes into generating returns in these products. This article is an attempt to provide the basics and also do a comparison with liquid funds, which is the category to compare with as far as performance goes. This is an article for mutual fund investors and not for those who are already familiar with the concept of arbitrage or have traded in derivatives.

Arbitrage funds seek to generate returns from the mispriced opportunities in equities between the cash and futures market. These funds are required to hold at least 65% in equities (including derivatives) in order to remain as an equity fund under the tax laws. This proportion of equities held varies depending on the mispriced securities that a fund manager is able to identify. Broadly, arbitrage funds’ returns stem from the following:

  • Arbitrage opportunity
  • The interest on deposits which are kept as margin collateral
  • The interest on the remaining debt and liquid component

The last 2 points mentioned above are simple. The first one is the ‘active’ call that a fund manager has to take. It is a function of the opportunities that the market offers – based on spread, open interest and the margin needed for the position. Let’s explain this a bit.

The spread is the difference in the price between the cash equity and the futures market. This primarily determines what returns arbitrage funds can make in their securities. As the spread widens, there is more opportunity to make money. When the spread turns negative – that is when the futures market is at a discount to the spot – then there is a higher risk of loss. This recently happened in March 2020 (and in earlier years too) when the equity markets crashed. But please note that not all the securities collapse to negative territory.

Open interest is the derivative positions that are not closed. Open interest provides a big picture of the trading activity in the market and whether there is increased or decreased participation. Usually, higher open interest enhances the chances of a healthy spread.

The job of a fund manager would be to identify the pockets of arbitrage opportunities from which to gain. The various combinations of opportunities are explained in this article. (Please note we do not have any call on the AMC’s fund linked here. This is merely for educative purposes).

Identifying opportunities may also mean identifying market-cap segments (large, mid) where the volatility is more. But the fund manager needs to balance that with the margins needed for such stocks.

The fund manager may also rollover positions – that is carry forward the current futures position to the next series. In this process too, he/she may generate some returns.

How arbitrage funds compare with liquid funds

Arbitrage funds India and liquid funds are very different products although their returns are quite comparable. This is because the difference between the spot and futures market is largely a reflection of the short-term interest rate. The additional returns in arbitrage, if any, come from the mispriced opportunities. In the absence of volatility, a liquid fund may provide better returns, pre-tax and they have.

Just look at the following data to understand how arbitrage funds have compared with liquid funds.

For this purpose, we took 3-years of data rolled for 1 day, 1 month, 3 months, 6 months and 12 months between August 2017-20. The following points emerge from such a comparison:

#1 Can generate negative returns

Arbitrage funds India fluctuate a lot on a daily basis and are not suitable for those wanting to park very short term money for days. The probability of negative returns is not nil even over 1 month. In other words, arbitrage funds are not as liquid and as low volatile as liquid funds for 1-3 month periods. You should prefer the safety of liquid funds returns in such cases.

#2 Have lower probability of beating liquid funds

While the risk of negative returns becomes nil in arbitrage funds, the pre-tax returns do not consistently beat liquid funds. The proportion of times arbitrage funds beat liquid fund returns (average returns) over a rolling 6-month period (data for last 3 years), when rolled daily, was just 33%. That means they beat liquid funds just one in 3 times. Over 1-year period, this proportion stands at just 19%.

#3 Pre-tax returns not superior to liquid funds

The rolling-returns graph over the 6 month and 12-month period (above) will also show that barring periods that yields suddenly saw a spike earlier this year, liquid funds have largely stayed ahead of arbitrage funds India even if it were a few basis points more. You will also see that in some 1-year periods like the one ending February-April 2019, the differential in return was well over 100 basis points. The data below will tell you that in almost all cases, the average returns of liquid funds have been higher.

As you can see, arbitrage funds do hold potential to generate higher returns in their best periods. But liquid funds have done better than arbitrage even in their worst periods (i.e., liquid funds’ minimum returns was still higher than that of arbitrage funds’).

#4 Liquid funds generate higher returns consistently

90% of the time, both arbitrage funds and liquid funds have managed to earn returns over 6%, in the period we considered. However, liquid funds travelled the extra mile, making the best of  short-term yields. The data below will tell you that liquid funds managed to generate over 6.5% return a good 80% of the times while arbitrage funds could achieve this only a third of the time.

#5 Tax efficiency is the clincher for arbitrage funds

Despite all of the above data, taxation makes the difference. If you are in the 20-30% tax brackets, the average returns of these categories suggest that arbitrage funds deliver superior post tax returns.

For example (forget the cess), the average post tax-1 year returns for arbitrage funds is 5.7% (at 10% LTCG). For liquid funds the same will be 5.3% if you are in the 20% tax bracket and just 4.7% for the 30% tax slab. Even for periods less than 1 year, this is the case, unless there are periods when liquid funds outperform significantly.

Only those in the 5% tax bracket really have a clear winner in liquid funds. For the others, it does mean you can load up on arbitrage funds – depending on your need. Liquid funds still make for low volatile options. Arbitrage funds can at best be a part of your short-term portfolio.

What’s the scenario now?

As we see it, the yields of liquid funds at around 3.4% (June 2020), clearly make a better case for investing in short-term FDs unless you are using liquid funds to do STPs or prefer liquidity to the lock-in FDs. Liquid funds could also be pulled down by recent regulations that require mark-to-market of securities over 30 days. But the story has not been too pleasant with arbitrage funds either. While fund managers have spoken of improving spreads post the market crash in March, it has been a see-saw for arbitrage funds in recent times. The data below is a simple annualized return of 1-month rolling returns. It will clearly tell you that arbitrage funds too are struggling to deliver.

Please note that the returns have been annualized to make them easy to compare (with FDs as well). They are not an indicator of future performance. Also note that individual arbitrage funds may have far higher returns than the averages given above.

 The arbitrage market, too, was troubled by a few events in the past 3-4 months. According to a note put out by IDFC MF:

  • The increase in margins on stock futures has reportedly caused HNI/retail activity to move away from the futures market to options, thus putting pressure on MFs who by default become large participants.
  • The open interest, which is a key requirement for healthy spreads, reduced again in May 2020. The size of positions in some stocks that entities can take, reduced therefore reducing market participation.
  • Higher FPI participation in index futures than stock futures impacted stock futures liquidity
  • Lower FD rates and short-term rates has meant that both FDs used as collateral and other debt did not earn much nor compensated for the sliding arbitrage opportunities.

Where to invest?

While the market participation has increased since, and individual fund managers  have stated an improvement in spreads, the returns of arbitrage funds are still way below their averages. It would either need a wide market breadth or significant volatility in the market to reverse this scenario.

  • To this extent, arbitrage funds may need a longer time frame (6 months plus), although their risk, post a 1-month holding, has traditionally been almost nil. Hence, for a period of less than 6 months, you need to be wary of taking exposures. And even beyond that, arbitrage funds cannot entirely substitute debt.
  • Liquid funds are unlikely to compete with FDs in the less than 6-month period and may just about manage to stay in line with arbitrage funds, likely trailing some of the best arbitrage funds.
  • For the 6 months to 1-year period, it may be a tug of war between fixed deposit rates and arbitrage funds, depending on the kind of rates your bank offers and whether you are in the 20% or 30% tax bracket. If you’re in the 5% tax bracket, you are better off staying with FDs.
  • For those of you who do not use arbitrage funds, there is no need to seek one unless you have familiarity with the product. It is best to leave existing money in liquid funds (given their liquidity and low volatility) and seek any fresh short-term parking in FDs, until the yields in liquid funds show improvement.

You can check our Prime Funds for various debt options as well as our recommended arbitrage fund. Alternatively, you can register for free to use our MF Review tool to check whether the arbitrage funds you hold have a buy/hold/sell recommendation by us.

To sum up, returns are drying up. Have to bear it for some time, folks!

Share via Whatsapp
Tweet it out
Share on FB
Post on LinkedIn

More like this

Please note that any specific queries on any of our recommendations will be answered ONLY through email. If you are a subscriber, please mail  Only general queries or discussions will be answered through the comment section of the blog. For full details, please refer to this post – How to communicate with PrimeInvestor.

16 thoughts on “Arbitrage funds vs liquid funds – which one to invest in?”

  1. narendra parekh

    My querry is- what are the criteria for charge for early redemption within one year in both arbitrage and liquid funds. What are the tax implications on interest?

    1. Every fund will mention something called exit load. You can check that. Tax is on capital gains. 15% if withing a year. Else 10%. Vidya

  2. Hello Vidya
    Very nice article with clear explanation. Can Arbitrage funds be used for parking money and doing STPs to equity/index funds? Of course I do understand the 6 months waiting period guidance suggested in the article. How does the Arbitrage funds compare with Ultra short term funds (which give slightly higher return than liquid funds) for the STP purpose?

    1. In a rate upmove scenario, ultra short is likely to clearly beat arbitrage. If your motive is primarily tax efficiency, you may. thanks, Vidya

    1. PSU and banking funds can be very volatile given their avg. maturity (and also trading of the bonds). They need a min2 year time frame and not meant for emergency funds. Of course, if you have held for over 2 years, you can always use these funds to withdraw any sum needed. thanks, Vidya

  3. Hi Vidya
    Well explained. In the case of an arbitrage fund, if the whole play is utilising the spread between spot and futures market, why there is so much difference in performance between funds of different AMCs? Isn’t it somewhat commoditised? They all should equally be able to capture the opportunities.

    1. Hello Sir, Sorry about the delayed reply. The differential in arbitrage fund returns isn’t that high, actually, barring the extreme ones (top and bottom). Also, it is not entirely commoditised for various reasons, few of which I will provide here: the universe of stocks with F&O is little under 200 – a decent size, though not large no. – providing diverse opportunities to identify and take positions. Second, funds may use index futures or stocks. Not all funds behave alike. Third, not all of them simply take a position and wait for expiry. They may trade in-between or they may roll over. Four, depending on the margin needed for individual stocks, how much they keep as FD (for collateral) will also have a say on returns. Fifth the rollover can also provide different returns. Sixth, the actual debt (outside of collateral) also determines returns. thanks, Vidya

      1. Thanks for the detailed explanation. You are also right there is no much difference in the return between funds.

  4. Brilliant article
    It gives so much clarity as well as a clear guidance on what to do.

    If I may add just one point which I feel can help some investors take a decision is the redemption time. A lot of investors use Liquid funds as a part of their emergency fund. Redemption from most Liquid funds take anywhere between a few minutes to a maximum of a day – depending upon AMC and the redemption amount.

    In case of Arbitrage fund, the redemption is like an Equity fund and may take a few days (worst case is if you have a weekend in-between).

    So for the purpose of Emergency fund, an Arbitrage can never be a replacement of Liquid Fund (or an FD) irrespective of the Tax slab.

    I hope you’ll agree.


    1. Good point! Totally agree. An arbitrage fund cannot be a substitute for the traditional emergency options. thanks, Vidya

  5. Hello madam,
    I am in 30% tax bracket & have yearly expenses like corporation tax, term insurance premiums or interest payments , etc. For that I had set up monthly SIPs of around Rs.30000/- in Arb funds from last 5-6 years.Holding period is more than one year. Due to my tax bracket I purposefully avoided liquid funds. Now after reading your article I have feeling that I am right. But last two months , arbitrage funds returns are reducing , in fact they are into negative territory. Still I should continue arbitrage funds.

    1. HEllo Sir, we have discussed why arbitrage funds are underperforming and what to expect from them. We also stated in the last line, that returns are drying up in general. So there is little choice but to grin and bear. But please make sure you have a mix of short-term FDs, liquid and arbitrage funds. It is good for all investors to not get too fixated with taxation alone. thanks, Vidya

Comments are closed.

Register for FREE!

Gain instant access to more PrimeInvestor articles, researched products, and portfolios

The essence of PrimeInvestor

Register for FREE!

Gain instant access to more PrimeInvestor articles, researched products, and portfolios

Legal Disclaimer : PrimeInvestor Financial Research Pvt Ltd (with brand name PrimeInvestor) is an independent research entity offering research services on personal finance products to customers. We are a SEBI registered Research Analyst (Registration: INH200008653). The content and reports generated by the entity does not constitute or is not intended to constitute an offer to buy or sell, or a solicitation to an offer to buy or sell financial products, units or securities. All content and information are provided on an ‘as is’ basis by PrimeInvestor Financial Research Pvt Ltd. Information herein is believed to be reliable but PrimeInvestor Financial Research Pvt Ltd does not warrant its completeness or accuracy and expressly disclaims all warranties and conditions of any kind, whether express or implied. The services rendered by PrimeInvestor Financial Research Pvt Ltd are on a best-effort basis. PrimeInvestor Financial Research Pvt Ltd does not assure or guarantee the user any minimum or fixed returns. PrimeInvestor Financial Research Pvt Ltd or any of its officers, directors, partners, employees, agents, subsidiaries, affiliates or business associates will not liable for any losses, cost of damage incurred consequent upon relying on investment information, research opinions or advice or any other material/information whatsoever on the web site, reports, mails or notifications issued by PrimeInvestor Financial Research Pvt Ltd or any other agency appointed/authorised by PrimeInvestor Financial Research Pvt Ltd. Use of the above-said information is at the user’s own risk. The user must make his own investment decisions based on his specific investment objective and financial position and using such independent advisors as he believes necessary. All intellectual property rights emerging from this website, blog, and investment solutions are and shall remain with PrimeInvestor Financial Research Pvt Ltd. All material made available is meant for the user’s personal use and such user shall not resell, copy, or redistribute the newsletter or any part of it, or use it for any commercial purpose. PrimeInvestor Financial Research Pvt Ltd, or any of its officers, directors, employees, or subsidiaries have not received any compensation/ benefits whether monetary or in kind, from the AMC, company, government, bank or any other product manufacturer or third party, whose products are the subject of its research or investment information. The performance data quoted represents past performance and does not guarantee future results. Investing in financial products involves risk. Investments are subject to market risk. Please read all related documents carefully. As a condition to accessing the content and website of PrimeInvestor Financial Research Pvt Ltd, you agree to our Terms and Conditions of Use, available here. This service is not directed for access or use by anyone in a country, especially the USA, Canada or the European Union countries, where such use or access is unlawful or which may subject PrimeInvestor Financial Research Pvt Ltd or its affiliates to any registration or licensing requirement.

Aditya Birla Mutual Fund • Axis Mutual Fund  Baroda Mutual Fund BNP Paribas Mutual Fund • BOI AXA Mutual Funds Canara Robeco Mutual Fund • DSP Mutual Fund  • Edelweiss Mutual Fund
Essel Mutual FundFranklin Templeton Mutual FundHDFC Mutual FundHSBC Mutual FundICICI Mutual FundIDBI Mutual FundIDFC Mutual FundIIFL Mutual FundIndiabulls Mutual FundInvesco Mutual FundITI Mutual FundKotak Mahindra Mutual FundL&T Mutual FundLIC Mutual FundMahindra Mutual FundMirae Asset Mutual FundMotilal Oswal Mutual FundNippon India Mutual FundPGIM Mutual FundPPFAS Mutual FundQuant Mutual FundQuantum Mutual FundSahara Mutual FundSBI Mutual FundShriram Mutual FundSundaram Mutual FundTata Mutual FundsTaurus Mutual FundsUnion Mutual FundsUTI Mutual FundsYes Mutual Funds

Equity: Large Cap Funds | Mip Cap Funds | Large And Mid Cap Funds | Small Cap Mutual Funds | Contra Mutual Funds | Dividend Yield | Focused Mutual Funds | Find Top Index Funds | Best Sector Funds | Thematic Mutual Fund | Best Value Mutual Funds | Equity Linked Savings Scheme | Tax Saving Funds

Debt: Banking And PSU Funds | Corporate Bond Funds | Credit Risk Funds Mutual Funds | Dynamic Bond Funds | Floating Rate Funds | Gilt Mutual Funds India | Find Top Liquid Funds In India | Long term debt funds | Low Duration Funds Debt Funds | Medium Duration Debt Funds | Medium To Long Duration Funds | Money Market Debt Funds | Overnight Debt Funds | Short Duration Debt Funds | Ultra Short Term Debt Fund
Hybrid: Aggressive Hybrid Funds | Arbitrage Mutual Funds | Balanced Advantage Mutual Funds | Conservative Hybrid Funds | Dynamic Asset Allocation | Equity Saving Funds | Multi Asset Funds | Multi Asset Allocation
Mutual fund rolling returns by category: Balanced Advantage | Conservative Hybrid Fund | Corporate Bond | Dividend Yield | Dynamic Bond | Equity Linked Savings Scheme | Floating Rate | Index Funds | Large and Midcap fund | Large Cap Fund | Liquid funds | Low Duration | Mid Cap Fund | Multi Cap Fund | Short Duration | Small cap Fund | Solution Oriented – Childrens Fund | Ultra Short Duration

Login to your account