Liquid funds are great. They are safe, secure and provide liquidity to the portfolio. However, they get taxed as debt schemes. This makes the post tax-return low for investors, especially for those in the 30% tax bracket. That's one of the reasons for the popularity of arbitrage funds that give returns similar returns to Liquid schemes but are completely tax-free after the one-year holding period.
What are they? These are funds that invest in equities and take offsetting positions through derivatives like futures. As such, there is no exposure to market movements and investments are relatively safe.
USP? Get returns similar to liquid funds with the tax benefit of equity funds (tax-free after one year).
Where do they invest? These funds invest in cash market (stocks) and hedge them using derivatives (futures etc.) The returns they make are the difference in the pricing between the cash market and futures market. For those who are fairly aware about futures, these funds return the risk-free rate that goes in pricing the futures.
Wait, that sounds complex. Is it really safe? They actually are safe as far as market risk is concerned. You literally have exposure to no major risk. Even during the worst time in recent history, these schemes delivered positive annual returns. Though understand this, these funds are relatively volatile as compared to liquid schemes. While over a longer period of time, say more than 3 months, the rate of return may be equal to liquid schemes, the price movement will be slightly more bumpy for arbitrage funds.
Why should you invest? Short answer, tax-benefits. That's the only driver for interest in these schemes. While Liquid schemes and arbitrage schemes are both currently giving ~6.5% returns, the post-tax returns (assuming a 30% bracket) after one year (but before 3 years) for liquid schemes is ~4.5%, while for arbitrage funds it is still ~6.5%. As such in terms of liquidity and exit load, liquid schemes have better treatment over arbitrage funds.
Who should consider investing? Anyone who wants to invest in safe investments for more than a year, and wants better post-tax returns.
Expowealth take - Liquid schemes have their special need - either as a store of value for emergency situations (in which case safety and liquidity matters more) or for temporarily parking your investments (in which case the differential returns with arbitrage funds don't matter much). While the post tax returns are definitely better for Arbitrage funds, they are not substitutes for liquid funds. One may perhaps add these schemes for higher returns in lieu of other debt schemes for an investment horizon strictly between 1-3 years, especially if you are in the 30% tax bracket.
Hope this helps.