The Covid-19 pandemic has made people realise the importance of building an emergency fund to deal with possible medical emergencies, salary cuts or job losses. Since the fund can be needed any time, it is usually invested in fixed rate instruments so that the returns can be known with certainty.
However, sharp interest rate cuts by the Reserve Bank of India (RBI) to combat economic slowdown have impacted returns of most fixed income investments. The widely popular liquid funds, too, have been hit. Some investment experts recommend arbitrage funds as an alternative to liquid funds. These funds buy shares in the cash market and sell an equal number of shares in the futures market, making money from the price difference between the two markets. Since the equity positions are fully hedged, market risk is largely eliminated. Can they be a substitute for liquid funds and other debt instruments such as bank fixed deposits (FDs)?
The Best Bet
Liquid funds and arbitrage funds are used to park money for the short term. Both have returned less than 3 per cent on a trailing basis in the past one year. Cumulative rate cuts of 250 basis points (1 basis point = 1/100th of a per cent) by the RBI since February 2019 have hurt returns from liquid schemes. In 2019, they had returned 6.33 per cent on an average. In 2020, this fell to 4 per cent.
Even though their returns have been similar of late, arbitrage funds have a taxation advantage. Sahil Arora, Senior Director, Paisabazaar.com, says post-tax returns from arbitrage funds can be higher than what liquid or debt funds generate, for those in higher tax slabs. In liquid funds, short-term capital gains are taxed according to the investor’s tax slab, while long-term capital gains are taxed at 20 per cent with indexation (adjusting for inflation). In arbitrage funds, short-term capital gains are taxed at 15 per cent while long-term gains attract 10 per cent tax if the profit is over `1 lakh. Arbitrage funds invest 65 per cent or more money in stocks and the rest in short-term debt instruments. That is why they are treated like equity mutual funds for tax purposes. “People in higher tax brackets can get better post-tax returns from arbitrage funds,” says Nitin Shahi, Executive Director of Findoc Financial Services Group.
However, some experts say that arbitrage funds are more difficult to manage than liquid funds. “For short-term goals, the intention is usually to protect the corpus and not enhance returns or pay less tax. Arbitrage funds have equity derivatives, which are volatile, as the underlying asset,” says Anup Bansal, Chief Investment Officer, Scripbox, a digital wealth management service. Liquid funds are safer as they invest in short-term money market instruments with up to 91 days maturity, making them less sensitive to interest rate changes. They usually hold high quality paper and are fairly liquid (T+1 day).
“Interest rates are at historic lows, bringing down returns of liquid funds, but this doesn’t mean investors should move out of these funds,” says Pankaj Pathak, Fund Manager-Fixed Income, Quantum Mutual Fund. Liquid funds are meant for very short-term goals and so the objective should be first safety and then liquidity, he says. “Investors should keep risks in mind while looking at alternatives,” he adds.
A Costly Deal
While liquid funds levy a small exit load if money is withdrawn in the initial seven days, arbitrage funds charge a relatively higher exit load if redemption is done within 30 days of the investment. Their expense ratio is also higher. According to Value Research data, while liquid funds’ expense ratio is in the range of 0.13 per cent and 0.90 per cent, arbitrage funds charge between 0.86 per cent and 1.82 per cent. That is why Bansal prefers liquid funds for short-term goals.
The Traditional Way
Perturbed by low returns from liquid funds, some investors are shifting to bank FDs. But returns from FDs are taxed according to the person’s tax slab. Liquid funds fare better than bank FDs on taxation (see Risks & Benefits).
Bank FDs for periods up to six months are offering around 4 per cent returns, which can look attractive compared to what liquid funds have been able to generate of late. But mutual fund experts still prefer liquid funds due to better liquidity and post-tax returns. They say post-tax returns on very short tenure FDs (<6 months) are comparable to yield-to-maturity on liquid funds. So, investors deciding between liquid funds and bank FDs should consider liquidity needs, investment horizon and taxation.
“Unlike bank FDs, liquid funds have no lock-in and are more tax efficient in the long term,” says Priti Rathi Gupta, Founder, LXME, a financial platform for women. Rathi says an FD attracts tax on interest received every year whereas one has to pay tax on liquid mutual funds only at the time of liquidation. If the emergency fund is not used for three years, investors will gain from the lower taxation in liquid or overnight funds.
A Tactical Call
Fund managers expect the RBI to move to ‘orderly evolution of the yield curve’ earlier than expected due to high inflation. Lesser intervention by the RBI could push bond yields higher. A rise in interest rates will benefit liquid funds way before it starts impacting bank FD rates.
Bond yields, says Pankaj Pathak, have bottomed out. He expects yields to rise over the next one-two years. At this point in time, where fixed deposit rates are at historical lows, liquid funds could be a better option than long-term FDs, he says. “Liquid funds invest in up to 91-day debt securities which move higher when interest rates rise. FD rates remain fixed even in a rising interest rate cycle,” says Pathak.
However, while selecting a liquid fund, investors should be cautious and also look at the credit quality and liquidity of the fund’s portfolio.
Look at Real Rate of Return
Mutual fund managers advise investors to look at real returns. “Twenty years back, when liquid funds were giving 8-9 per cent, inflation was 9-10 per cent. So, my real return was zero. Today, when liquid funds are giving 3-4 per cent, bond funds are giving 5 per cent and inflation is at 4 per cent. As an investor, we need to learn to look at our real rate of return. The return net of inflation is what we are earning,” says Kalpen Parekh, President, DSP Mutual Fund. He says 1-2 percentage points above inflation is a good rate of return.
Both arbitrage and liquid funds have their pros and cons. While arbitrage funds score higher on the taxation front, liquids offer better stability and liquidity. The choice of funds should depend on your investment goals.