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Should I invest in an arbitrage fund?

You can rule out liquid funds as they are meant to park money for a short period of a few weeks to months

I have ₹2 lakh. I would need this money after two to three years. Should I invest in a liquid scheme, dynamic bond fund or arbitrage fund?
- Jyotirup Chatterji

You can rule out liquid funds as they are meant to park money for a short period of a few weeks to months. That means you are left with two options: dynamic bond funds and arbitrage funds. Since you haven't stated your investment horizon clearly, we are offering you a general answer (with some ifs and buts).

If you are not sure about your investment horizon and doubt that you would need the money before three years, you should opt for arbitrage funds. Arbitrage funds are considered equity funds for the purpose of taxation and returns from them are tax free if you hold them for more than 12 months. If you know for sure that you would need the money only after three years, opt for dynamic bond funds. Debt mutual funds work best, especially if you are in the higher income tax slab, if you hold them for more than three years. Then the returns from them qualify for long-term capital gains tax of 20 per cent with indexation benefit. Short-term capital gains from debt funds are added to the income and taxed as per the income tax slab applicable to the investor.

Some may argue that if interest rates fall soon, dynamic bonds may offer superior returns even after accounting for short term capital gains tax. That is a possibility.

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