When planning our asset allocations, we usually think about equity and fixed income for our different investment needs. Equity investments are made over long investment tenures (usually 5 years or longer) and primarily for the purpose of capital appreciation.
Fixed income investments are made for short to medium tenors (1 to 3 years), primarily to meet our income needs. Apart from these two investments needs, we also should plan for our very short term (less than 1 year) needs e.g. creating an emergency fund to meet sudden expenses, parking one-time cash-flows or surplus funds for a short duration to meet an upcoming expense or investment. For very short term investments, we should ensure that the investment has very low risk (high degree of capital safety) and high liquidity (we can redeem the investment at any time, without incurring any cost).
Liquid funds, ultra-short duration debt funds, money market funds, low duration funds etc. are suitable for very short-term investment needs. These funds invest in money market or debt securities with very short residual maturities and have very low interest rate risk (compared to longer duration debt funds).
They are also highly liquid – liquid funds for example, have no exit loads and redemption requests are processed within one business day (subject to cut-off times). These funds are very popular with corporate and institutional investors for parking their surplus funds.
Retail investors usually keep their surplus funds lying in their savings bank account, but liquid and other very short duration funds can give much better returns than savings bank interest.
Another category of funds known as arbitrage funds can be excellent substitutes for liquid funds. Unlike liquid and other debt funds, arbitrage funds enjoy equity taxation enabling them highly tax efficient returns.
What are arbitrage funds?
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