Arbitrage Funds – What are they?
“I want my investment to be safe, tax-free and give me higher returns than an FD”.
In search for this “ultimate” investment, one of the strategies investors use is arbitrage.
Simply put, you buy a stock in the cash market and you book an advance sale of it in the futures market where it is being quoted for a higher price. By locking the price in advance, you lock your return as well.
Essentially, this is what arbitrage funds do.
An arbitrage fund exploits price differential between cash and future markets using stocks or commodities as an underlying investment. In the process, this limits the upside return since the selling price is pre-determined.
Isn’t that good? May be not.
Let’s understand arbitrage funds a little more.
First a few facts about Arbitrage Funds
One, the typical portfolio of an arbitrage fund constitutes of stocks, future contracts, debt and money market investments. Since they invest in a combination of investments, they are hybrid in nature.
Two, the benchmark of most arbitrage funds is a liquid fund index. What it means is that they intend to match returns of a liquid or ultra short term debt fund.
You ask – “why does a fund that invests predominantly in equity and equity related investments produces returns of debt investments?”
Worse, why do you take the risk of an equity investment and still get debt like returns? The next fact answers your question.
Three, the tax treatment of an arbitrage fund is like equity. After 1 year of holding, you don’t have to pay any long-term capital gains tax. And short term, that is less than 1 year, gain is taxed at only 15%.
This is the single biggest reason for investment in arbitrage funds. Though you earn debt-like returns, they are tax-free after 1 year. For those in the highest tax bracket, this is a huge incentive.
No wonder, many investors are pouring money into arbitrage funds, specially for short term.
- Should you really invest in these funds?
- Is the tax benefit so large?
- Can you just stick with the debt funds?
Let’s do a comparison.
A comparison of Arbitrage Funds, Ultra Short Term and Liquid Funds
In the following table, we have compared some of the popular arbitrage funds along with ultra short term and liquid funds.
Source: Unovest Research; All scheme data is for direct plans and as on Sept 24, 2016. Best and Worst performance is for any 12 month period in the fund’s existence starting from January 1, 2013.
Purely on the basis of returns, liquid funds and ultra short term funds are doing better than the arbitrage funds.
Even for the best and worst performance in any 1 year period, the arbitrage funds lose out to the liquid and ultra short term funds.
It seems to be a no-brainer as to what you should go for? But wait. What about the taxes? That could change the result completely.
Let’s consider taxes
We did something different here. We took only the worst and best performance of the funds. Assuming you book these best and worst returns, what is your post-tax return in each case?
Further 2 periods are considered, one less than 1 year and other more than 1 year.
The rate of tax applied is 30% for short term gains on debt funds. The rate of tax for arbitrage funds for short term is 15%.
As you are aware, from a tax point of view, debt fund gains are treated as short term if sold within 3 years of purchase.
The results are in the table below. The last two columns show the post tax returns (more than 1 year and less than 1 year) for both the worst and the best performance of the fund for any given year.
Here are the observations:
- It is clear that in less than 1 year period, if you book the worst returns net of taxes, the arbitrage strategy even with the use of equities is relatively less rewarding. For less than 1 year, it is better to invest money in the debt funds.
- For the investor in less than 30% tax bracket, ultra short term funds deliver better returns, even after paying tax.
So, what should you do?
If you are in the highest tax bracket with loads of luck on your side, you probably get the best returns and hence arbitrage funds make sense. To everyone else, ignore them.
The useful guideline for you to consider an investment between arbitrage and debt funds is – “Don’t use a gun to kill a mosquito”.