Capitalists in SA often seek a safe, efficient avenue of investment that is relatively liquid and offers reasonable returns. The choice typically comes down to two funds: arbitrage or liquid. Both types of funds address the short-term requirements of an investor’s finances but differ in their operation and on the grounds of risk profits. While arbitrage funds reap returns from the price differentials between different markets, liquid funds invest in short-term money market instruments to attain stability. Knowing the essential differences between these two fund types will help quarters get acquainted with and develop informed judgments relating to investment decisions.
Is the Arbitrage Fund a Liquid Fund?
To this day, arbitrage and liquid funds fall under the category of short-term investment instruments. However, they do vary in essential manners. While arbitrage schemes look forward to making ventures that exploit price inefficiencies between two different markets by typically buying and selling the same type of asset in diverse fields at variable prices, a good example can be buying stock from one sector when the prices are low and selling the same in another space when the prices are comparatively high, thereby earning from the differential price between the buy and sell.
Liquid schemes do the opposite: they invest in highly liquid and low-risk money market instruments, including Treasury bills, commercial papers, and certificates of deposit. Their main concern is preserving their money with moderate returns and minimal risks. The truth is that arbitrage funds are more complex compared with liquid funds because they rely on market volatility to make profits. Whereas both types provide their liquidity, arbitrage funds are not considered to fall under the category of liquid funds.
The return from an arbitrage fund may also vary in contemplation of market volatility; however, liquid funds are much more stable and give predictable returns that are much lower. An arbitrage scheme is perfect for capitalists benefiting from market volatility without completely diving into the equity fields.
What is the Difference Between Arbitrage & Liquid Funds?
They belong to a different venturing strategy and risk profile. Schemes that employ arbitrage typically take advantage of price differences within various markets for the same underlying asset. The fund manager buys in the market where the asset is priced low and simultaneously sells in the market where its price is higher. This “arbitrage” creates a risk-free profit.
However, the returns on arbitrage funds depend significantly on the stock market’s volatility and how frequently such pricing inefficiencies crop up. These funds generally fall under the equity schemes and can offer higher returns than liquid funds. However, they also come with a slightly higher risk. On the other hand, liquid schemes venture into highly liquid, short-term money market instruments. Their objective is to book slightly higher returns with the protection of capital, unlike savings accounts or fixed deposits. Thus, these funds are suitable for investors who want to park their money for a very short period with minimal risk. Liquid funds generally offer stable and predictable returns, often not entangled by market volatility.
Another critical difference is taxation. Since arbitrage funds are classified as equity funds, they receive some anomaly in the taxation system that liquid funds do not; if held for more than a year, the tax treatment will be more favorable. Thus, liquid schemes will be taxed as debt
What Are the Pros & Cons of Arbitrage & Liquid Funds?
Arbitrage Funds
Pros:
- Market-Linked Returns: The funds in this category offer a safer way to exploit volatility in the market, reaping returns by way of price spreads between markets.
- Tax Efficiency: Arbitrage funds are equity-linked and enjoy more favorable taxes, primarily if held for over one year.
- Moderate Risk: Although factually tied to equity markets, arbitrage funds offset many of the usual risks with their hedging directions in the stock market.
Cons:
- Market Dependence: Return on arbitrage funds depends on market volatility and pricing inefficiencies, which are never known in advance.
- The returns will be limited: Although it bears no risk, only a few arbitrage opportunities are available. In periods of low volatility, these returns will be hardly exciting.
- Complexity: These funds are more complicated to understand because, unlike simple liquid funds, they involve understanding market arbitrage strategies.
Liquid Funds
Pros:
- Stability: Liquid funds provide stable, predictable returns, hence excellence in parking funds for the short term.
- Liquid Nature: The very name suggests that money is comfortably accessible within these funds; hence, they are best suited for emergency funds or to make temporal investments.
- Low risk: Liquid funds invest in high-quality debt instruments that mature quickly and are very low-risk.
Cons:
- Lower returns: Liquid funds tend to offer lower returns, which are in comparison to arbitrage or equity funds. They often just about beat the inflation rate and are impractical for long-term growth.
- Taxation: Liquid funds are taxed like debt funds; further, the taxation of short-term capital gains is at the individual’s marginal rate of taxation, which may not be as attractive as in the case of arbitrage funds.
- Not Ideal for High Growth: Liquid funds are not meant for investors seeking high growth in their capital because their investment objective is majorly capital preservation.
Are Arbitrage Funds Still Worth It?
In a nutshell, arbitrage funds are still a worthy investment vehicle for the South African investor who wishes to reap their full benefits from the vagaries of the stock market and less substantive risk exposure. Leveraging market inefficiencies enables an arbitrage fund to generate reasonable returns amidst volatile markets. This factor makes it an attractive option for a conservative investor who wants to benefit from the equity markets without total market risk exposure.
However, the values of arbitrage funds keep changing with the existing market. During low volatility, arbitrage opportunities are lesser, and therefore, they entail lesser returns. Therefore, investors must be sure whether they can accept the uncertainty concerning the return expectations.
Besides this, the other drawback is that an arbitrage fund is considered a mid-term investment, where, ideally, a holding period of one year is considered vital to gain maximum benefit from the tax. For a shorter time horizon, the returns may not be attractive. Despite these challenges, arbitrage funds remain pertinent for investors considering an investment combining low-risk equity exposure. They are most useful during periods of market volatility where price inefficiencies are more frequent.