If it comes down to choosing Between the two :
Arbitrage Fund wins hands down.
Let’s take example for people who are in 30% tax slab as it will make the difference more stark.
Why do you use Liquid Fund?
As the name suggest people use it for liquidity. If you take out money from liquid fund which is considered a debt fund before 3 years you have to pay marginal rate of tax which can be as high as 30%!!
In contrast short term tax in Arbitrage fund is 20%( equity category) and after 1 year is 0 if the capital gain is less than 1 year. Which means even if you have 10 lakh in arbitrage after 1 year you pay zero tax!
Let’s look at portfolio of some of the best Liquid Funds in the market. Kotak Liquid Fund.
Let’s look at DSP liquid Fund
Well I see almost 10–15% portfolio in companies like Aditya birla finance ,tata capital ,Trapti Trading, chambal fertilizers etc. They are very safe I agree but even ILFS was AAA.The point is its not zero risk like what most people assume.
Now let’s look at portfolio of an arbitrage Fund. Reliance Arbitrage
70% equity= Pure arbitrage of cash future so zero risk of principal loss
20% FD of banks(HDFC,Federal) = very safe
11% GOI debt/blue chip debt = very safe
In terms of Risk also arbitrage is much better than liquid and chances of loss of principal are lower.
3 . Returns
Well there is not much difference in pretax return of Liquid fund and arbitrage fund . Close to 7–7.5%. After tax Arbitrage Fund is better.
Conclusion: If someone wants to take credit risk then focus on funds which invest in credit and P2P Lending. If someone doesn’t want any credit risk focus on Bank FD and arbitrage.
Liquid Fund neither provide absolute safety nor great returns and is a compromise between the two
My article on risk free FD portfolio :