Which One is the Better Option: Liquid Funds or Arbitrage Mutual Funds Instead of Fixed Deposits?

by Alina Khan

Published On Jan. 29, 2024

In this article

In the realm of financial planning and investment, one often encounters the dilemma of choosing the right instrument to park surplus funds. Fixed Deposits (FDs) have long been a preferred choice for risk-averse investors in India. However, the financial landscape has evolved, presenting alternatives such as Liquid Funds and Arbitrage Mutual Funds. These alternatives offer the potential for higher returns while maintaining liquidity and minimizing tax implications. In this article, we will delve into the intricacies of Liquid Funds and Arbitrage Mutual Funds to help you make an informed decision.

Understanding Fixed Deposits (FDs)

Fixed Deposits, offered by banks and financial institutions, have traditionally been considered a safe harbor for investments. They are characterized by a fixed interest rate and a predetermined tenure. Investors park a lump sum amount for a specific period, and upon maturity, they receive the principal along with the interest earned.

Pros of Fixed Deposits:

  • Safety: FDs are backed by the deposit insurance guarantee of up to ₹5 lakh per account, making them one of the safest investment options.

  • Predictable Returns: Investors know the exact returns they will receive at the end of the tenure, making it ideal for risk-averse individuals.

  • Fixed Tenure: The fixed tenure ensures that the invested amount remains locked in for a specific period, promoting disciplined savings.

  • Tax Benefits: Tax-saving FDs offer deductions under Section 80C of the Income Tax Act.

Cons of Fixed Deposits:

  • Low Returns: FD interest rates are typically lower than the returns offered by other investment avenues, potentially leading to erosion of purchasing power due to inflation.

  • Lack of Liquidity: Premature withdrawals may result in penalties, and the funds may not be readily available in case of emergencies.

  • Taxation: The interest earned on FDs is subject to taxation, which can significantly reduce post-tax returns.

Exploring Liquid Funds

Liquid Funds, a category of mutual funds, offer an alternative to traditional Fixed Deposits. They primarily invest in money market instruments and debt securities with short maturities. Liquid Funds are designed to provide high liquidity and relatively stable returns.

Pros of Liquid Funds:

  • Liquidity: Liquid Funds offer unparalleled liquidity, allowing investors to redeem their investments within 24 hours on business days.

  • Potentially Higher Returns: While not guaranteed, Liquid Funds have the potential to offer higher returns compared to FDs, especially in the current low-interest-rate environment.

  • Tax Efficiency: Capital gains in Liquid Funds are taxed at a lower rate for investments held for more than three years. For shorter durations, they are subject to short-term capital gains tax.

  • No Lock-In Period: Investors can enter and exit Liquid Funds without facing penalties or lock-in periods.

Cons of Liquid Funds:

  • Market-Linked Returns: Liquid Funds are subject to market risks, albeit minimal. Returns may vary based on market conditions.

  • No Fixed Returns: Unlike FDs, Liquid Funds do not offer guaranteed fixed returns, making them less predictable in terms of income.

Evaluating Arbitrage Mutual Funds

Arbitrage Mutual Funds, another category within the mutual funds universe, aim to capitalize on price differentials in the cash and futures markets of equities. They offer the potential for higher returns than Liquid Funds while maintaining lower risk levels compared to pure equity funds.

Pros of Arbitrage Mutual Funds:

  • Tax Efficiency: One of the key advantages of Arbitrage Mutual Funds is their tax efficiency. They are treated as equity-oriented funds for taxation purposes, resulting in a lower tax liability.

  • Stable Returns: Arbitrage funds tend to provide relatively stable returns since they aim to capture risk-free arbitrage opportunities.

  • Low Volatility: These funds typically exhibit lower volatility compared to pure equity funds, making them suitable for conservative investors.

  • Liquidity: Arbitrage Mutual Funds offer liquidity similar to Liquid Funds, allowing for quick access to funds when needed.

Cons of Arbitrage Mutual Funds:

  • Moderate Returns: While the returns are potentially higher than Liquid Funds, they are usually lower than those of pure equity funds. Investors seeking high growth may find these returns suboptimal.

  • Market-Linked: Arbitrage Mutual Funds are influenced by market movements, albeit to a lesser extent than pure equity funds. They are not entirely risk-free.

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Comparing the Options

Now that we have a clear understanding of Fixed Deposits, Liquid Funds, and Arbitrage Mutual Funds, let's compare these options based on various parameters:

  • Returns: While Fixed Deposits offer fixed, predictable returns, Liquid Funds and Arbitrage Mutual Funds have the potential for higher returns, especially when interest rates are low.

  • Liquidity: Liquid Funds and Arbitrage Mutual Funds offer high liquidity, allowing investors to access their funds quickly. Fixed Deposits, on the other hand, may impose penalties for premature withdrawals.

  • Taxation: Liquid Funds enjoy favorable taxation for long-term investments, while Arbitrage Mutual Funds benefit from equity-oriented taxation. Fixed Deposits are taxed as per the investor's applicable tax slab.

  • Safety: Fixed Deposits are considered one of the safest investment options due to deposit insurance. Liquid Funds and Arbitrage Mutual Funds carry minimal risk but are not entirely risk-free.

  • Lock-In Period: Fixed Deposits have a fixed tenure, which may or may not align with an investor's liquidity needs. Liquid Funds and Arbitrage Mutual Funds have no lock-in periods.

  • Risk Tolerance: Fixed Deposits are ideal for risk-averse investors looking for capital preservation. Liquid Funds and Arbitrage Mutual Funds cater to investors willing to take on slightly more risk for potentially higher returns.

Making an Informed Choice

The choice between Fixed Deposits, Liquid Funds, and Arbitrage Mutual Funds ultimately depends on your financial goals, risk tolerance, and liquidity requirements. Here are some scenarios where each option may be suitable:

  • Fixed Deposits: Ideal for conservative investors looking for guaranteed returns and capital preservation. They are suitable for short-term goals and emergency funds.

  • Liquid Funds: Suited for investors seeking liquidity, potentially higher returns than FDs, and favorable tax treatment. They are ideal for short to medium-term goals and parking surplus funds.

  • Arbitrage Mutual Funds: Suitable for investors with a slightly higher risk tolerance seeking tax-efficient returns. They are ideal for medium-term goals and capital appreciation.

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To Sum Up

In conclusion, while Fixed Deposits have been a traditional choice for risk-averse investors in India, Liquid Funds and Arbitrage Mutual Funds offer compelling alternatives. These mutual funds options provide the potential for higher returns, tax efficiency, and greater liquidity. However, it's essential to assess your financial objectives and risk appetite before making a decision. Diversifying your investments across these options based on your goals can also be a prudent strategy. Always consult a financial advisor to align your investments with your unique financial circumstances.

Read these articles to understand all about mutual funds and how you can invest in mutual funds with Wright Research:

  1. What is SIP in Mutual Funds? An Experts Guide

  2. The Crucial Role of Risk Profiling in Mutual Fund Investments

  3. How many funds should you have in your Mutual Fund Portfolio?

  4. What is Standard Deviation in Mutual Fund and How Does it Help in Portfolio Management?

  5. Smallcase vs Mutual Fund: Understand Difference and Similarities

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