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Last Updated : Jan 20, 2017 10:34 AM IST | Source:

Why you should be investing in arbitrage funds now?

Market volatility doesn't entail more risk for the investor in the case of arbitrage funds. In fact, arbitrage opportunities exist only when the markets are relatively unstable.

Jignesh Shah
Capital Advisors

In the last week of Dec 2016, while calendar year (amid De-monetization) was coming to end and we were on the way to 2017, few HNI clients called up, asking why ultra short term funds (UST) are giving negative return for last few days and how do we excuse ourselves from that.

Liquid and UST funds are supposed to be providing safe return which could be lower, considering lower duration. With safety of principal being priority, lower return is acceptable to them. Still, good number of UST funds gave negative return for couple of days in month of December.

That’s because yields of government securities hardened in month of December 2016, following no rate cut by RBI in monetary policy review of December 7. Benchmark 10 year g-sec yield hardened from 6.2% on December 6, 2016 to 6.6% on December 27, 2016.

Simultaneously, a few UST funds were carrying average maturity of more than 1.5 years. In fact, in some cases, UST Funds were carrying higher maturity / duration than that of short term debt funds / short term opportunities fund. That’s surprising. Probably positioning of funds was not clear to investors and/or to advisors.

Under such circumstances, to maintain safety of principal as a priority, what should investors do? Either move to liquid funds where maturity is lower than 91 days, or explore possibility of arbitrage funds.

What is arbitrage funds?

An arbitrage fund - a type of equity mutual fund - rides on the mispricing between the cash markets or spot markets on the one hand and derivatives or futures markets on the other. The arbitrage opportunities bring relatively risk-free returns to the investors. These funds are tailor-made for risk-averse investors and are a safe option to park money, when there is a persistent volatility in the market. These funds ride on market inefficiencies to reap benefits for the investors.

Market volatility doesn't entail more risk for the investor in the case of arbitrage funds. In fact, arbitrage opportunities exist only when the markets are relatively unstable. When the markets are stable, the arbitrage funds may not be that attractive.

Tax advantage also makes arbitrage funds an attractive bet. When the equity holdings in the cash market are held over and above 65%, these schemes are considered as equity funds, and that's a bonanza as far as tax efficiency is considered. The return one earns after holding these funds for more than one year are tax-free. Redemption income from these funds within the first 12 months could be taxed at 15% in terms of short-term capital gains tax. The dividends from arbitrage funds will not attract tax, as there is no dividend distribution tax on equity funds.

As far as returns are concerned, arbitrage funds normally fetch returns of 4-9%. Bank fixed deposits can fetch 5.5-9% and liquid funds somewhere between 5% and 8%. As noted earlier, arbitrage funds stand out, as the returns from these funds are tax-free after one year. FD and liquid fund returns are taxed as per the applicable tax slab rate.

Early exits from arbitrage funds attract nominal penalty, usually 0.25-0.5% in the first three to six months. This is called exit load in the industry jargon. After that, there are no charges. Liquid funds do not have penalties, but bank FDs charge a penalty of nearly 1% in case of premature withdrawal.

Arbitrage funds can be redeemed in two to five days as compared to fixed deposits, which could be encashed at the click of a button which ensures that the money is paid to your bank account on the same day. Liquid funds can be encashed the next working day.

When should one invest in arbitrage funds?

Does it make sense to invest only on a particular day or any day of the month, since roll-over of arbitrage position happens generally on expiry. It is preferable to invest in arbitrage funds in last week of the month, when roll-over of futures positions happen. Spreads between Cash and Futures position keep on fluctuating from starting of futures position to expiry. So, if we enter when spread between futures and cash has expanded, it benefits the investors as and when it converges towards the end of month on expiry of futures. And conversely, when one enters after spread has already reduced it would give lower return to investors, for the same month.

Generally, factors which drive these spreads are higher overall interest rates (short end of yield curve), excessive derivatives roll-over position, higher FII activities in the market, etc.

Which arbitrage fund should be preferred?

One has to be careful in selecting arbitrage funds, because some of them have higher exposure to the debt category. The equity and equity-related instruments must cross the minimum average of 65 per cent of total AuM to qualify as equity funds and to get the tax advantage associated with it. If this point is overlooked, the main purpose itself is defeated. Besides, few arbitrage funds, as per their internal mandate take 5% or so tactical position, which generates better return. However, the same may backfire, if tactical position goes wrong. Additionally, few of arbitrage funds have bulky wholesale investors. Exit of such institutional investors may create volatility in performance for rest of investors in the same fund. Hence, better to consider arbitrage funds, which are not overexposed to investments by institutions.

Who should invest?

If a person is in the lower tax bracket of 10 per cent, he will benefit more from liquid funds (which generally has higher return on pre-tax basis). He will be paying only 10 per cent on STCG (Short Term Capital Gains) on liquid funds, whereas short-term capital gains on arbitrage funds would attract 15 per cent. However, if you are in a higher tax bracket (20 or 30 per cent) and want to save on taxes, arbitrage funds would be a better option. With arbitrage funds, Long term capital gain will be completely tax free and short term gains are taxed only at 15 per cent. Alternatively, one can go for dividend option, as most of arbitrage funds have monthly dividend pay-out options and dividend from equity mutual funds do not attract dividend distribution tax.
Not sure which mutual funds to buy? Download moneycontrol transact app to get personalised investment recommendations.
First Published on Jan 18, 2017 10:27 am
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