Is there any investment option which can mimic the risk-return profile of a Debt mutual fund and is also a tax efficient one like an Equity oriented Mutual Fund? Do we have such an investment avenue? Yes is the answer.
Arbitrage Funds have the risk-return profile which is similar to Debt funds and they are also tax efficient ones. An Arbitrage mutual fund is similar to say a Liquid Debt Fund in terms of Returns and is like an Equity fund with respect to Tax implications. It is generally a risk-free investment option.
In this post, let us understand – What is the meaning of Arbitrage? What are Arbitrage Funds? How do Arbitrage Mutual Funds work? What is the tax treatment of capital gains on Arbitrage Funds? Arbitrage Funds Vs Debt Funds.
What is Arbitrage?
Arbitrage is the practice of taking advantage of a price difference between two or more markets. This can be done by exploiting the differences in the price of a Financial Security or Asset or Product (goods) by simultaneously buying and selling it in different markets. It is a short-term trading opportunity.
Let’s understand the concept of Arbitrage with an example.
Mr Saravana runs a decent hotel which serves only South Indian Tiffin Items. His hotel is very famous for Idlis. He sells Idli at Rs 10 per piece. The cost price of one Idli is Rs 7. So, he earns a net profit of Rs 3 (Rs 10- Rs 7) for each Idli sold. He is not happy with the quantum of net-profit. He wants to increase his profit margin without increasing the selling price.
One day, he tasted idlis in a near-by Bus stand canteen. The quality and taste of the Idlis are same. But the selling price of each Idli is Rs 5 only (whereas he is selling one Idly for Rs 10). So, he decides to buy Idlis from the canteen at Rs 5 and to sell at his hotel for Rs 10 each. In this scenario, he can make a profit of Rs 5 (Rs 10 – Rs 5).
What are Arbitrage Funds? How do Arbitrage Funds work?
The above practice of buying from one market and selling at a slightly higher price in a different market is called as ‘Arbitrage Opportunity’.
These kind of investment or trading opportunities exist in Financial Markets too. The financial securities like Stocks can be bought in CASH market and can be sold in DERIVATIVES market at a higher price.
For example – Share price of XYZ company can be quoting at Rs 1,000 per share in NSE Cash market (National Stock Exchange) and Rs 1,010 per share in Futures & Options market for the next month. So, an investor or fund manager can buy shares of XYZ at Rs 1,000 and at the same time sells XYZ share in F&O at Rs 1,010. On settlement date (Expiry day), the investor can make a profit of Rs 10. ( A Futures contract is a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.)
So, Arbitrage Fund is the one which tries to exploit the pricing imbalances (mispricing) which are available in the cash and derivatives markets. The strategy of an arbitrage fund is to trade in Cash & Derivatives market with an aim to generate debt fund like returns.
Another arbitrage opportunity can be when there is a difference in the prices of a Share quoted in the NSE & the BSE.
Portfolio of an Arbitrage Fund
The fund objective of a typical Arbitrage Fund in India is to generate reasonable returns by predominantly investing in arbitrage opportunities in the cash and derivatives segments of the equity markets and by investing remaining balance in debt and money market instruments (like Debentures, Commercial Paper, Certificate of Deposits etc.,).
For example : ICICI Prudential Equity Arbitrage Fund’s investment objective is ‘to generate low volatility returns by using arbitrage and other derivative strategies in equity markets and investments in short-term debt portfolio.’
As of 29th April, 2016 this arbitrage fund has a portfolio allocation of 65% in Equity & Equity derivatives, around 17% in Debt Securities, 10% in Money Market Securities and around 8% as idle cash.
Arbitrage funds can be classified as Arbitrage (or) Arbitrage Plus funds depending on the respective scheme investment strategy. Arbitrage Plus Funds’ execute investment strategies that may involve relatively more risk than usual arbitrage funds.
Best Arbitrage Funds
Below are some of the top performing and best Arbitrage Mutual Fund Schemes in India. These are Direct Plans with Growth option.
- HDFC Arbitrage Fund
- L&T Arbitrage Opportunities Fund
- Kotak Equity Arbitrage Fund
- ICICI Prudential Equity Arbitrage Fund
- IDFC Arbitrage Fund
- Reliance Arbitrage Advantage Fund
The average returns generated by the above funds in the last one year was around 7% and in the last 2 to 3 years the returns have been around 8.5%.
Below table gives us an idea about why investing in a Direct Plan is better than investing in a Regular of the same scheme. I have provided details about IDFC Arbitrage Fund here. The returns generate by the Direct Plan is better than the Regular Plan returns.The Expense ratio of the Direct plan is 0.37% and for the Regular Plan it is 1%.
(You may like reading : ‘What are Direct Mutual Fund Plans?’ & ‘Equity Mutual Fund Direct Plans Vs Regular Plans – Comparison of Returns‘)
Taxation of Arbitrage Funds
It is very important that you as an investor should know about the tax treatment & tax adjusted returns of an investment option before making any investment decisions.
From the above Returns table it is very clear that Arbitrage Funds can generate returns which are comparable to Short Term Debt Funds or Liquid Debt Funds and Fixed Deposits. So, what’s special about these funds when compared to Debt Funds or even Fixed Deposits??
For income tax purpose, the arbitrage mutual funds are classified as Equity oriented funds.
- Long Term Capital Gains on Arbitrage Fund
- If you make a gain / profit on your investment in an Arbitrage Mutual Fund scheme that you have held for over 1 year, it will be classified as Long Term Capital Gain.
- The long term capital gains on Arbitrage Fund are tax-free.
- Short Term Capital Gains
- If your holdings of an Arbitrage Equity mutual fund scheme are less than 1 year old i.e. if you withdraw your mutual fund units before 1 year, after making a profit, then the profit will be considered as Short Term Capital Gain.
- The capital gain tax rate of 15% is applicable on Short Term Capital Gains of Arbitrage Fund.
- Kindly note that if you are in 30% income tax slab rate, the interest income on Fixed Deposits will be charged at 30% (as per your income tax slab rate).
- The Short term Capital gains on Debt mutual funds too are taxed at 30% (as per your income tax slab rate) if the holding period is less than 3 years.
So, as per the current tax laws, the Arbitrage Funds have clear tax advantage over Fixed Deposits or Debt Mutual Funds.
Important Points to ponder upon before investing in Arbitrage Mutual Fund Schemes
- Arbitrage Funds can generate more and better returns when markets are volatile. The volatile markets can create arbitrage opportunities.
- These funds can generate better returns if major portion of fund corpus is invested in mid or small cap stocks or derivatives as they can be very volatile.
- If you opt for ‘Dividend’ option, then DDT (Dividend Distribution Tax) is not applicable on the dividend declared by the funds. The dividends received from Arbitrage Funds are tax-free.
- Though these funds mimic debt funds like risk profile but they cannot be considered as pure alternatives to Debt mutual Funds. In a declining interest rate scenario, Gilt Funds or Short-Term Debt Funds or even Dynamic Bond Funds can outperform Arbitrage Funds. In the first half of the 2015, Income Funds or Dynamic Bond funds (Debt funds) & Short-Term debt funds have outperformed the arbitrage funds thanks to the interest rate cuts.
- Kindly note that though these funds are treated as Equity funds w.r.t. taxation, but they may not generate returns like equity funds in the long-term.
- If you are looking for a tax efficient investment option for short term goals (1 to 2 year goals), you can consider investing in arbitrage funds.
- You can invest lump sum amounts in these funds for short-term goals. Systematic Investment Plan (SIPs) in these funds may not really make sense.
- You can consider these funds as one of the saving options when you are building your emergency fund.
- When your Financial Goal Target Year is nearing, you can switch from high risk investment options to these funds which have low-risk & are tax-free (more than 1 year).
- These funds have a very remote chance of generating negative returns. Even in 2008 when stock markets crashed, arbitrage funds gave positive returns in India.
- As these are risk-less opportunities, the returns may not be double digits.
- Arbitrage Funds can be a better choice if you are in the tax slabs of 20 to 30%, when markets are very volatile and when the interest rates are stable or increasing.
- Do watch out for Exit Loads of these funds. They can be higher than the debt funds.
- Arbitrage Funds are not allowed to SHORT in Cash Markets in India. So in a bear market their performances can suffer.
- These funds have high turnover and high transaction costs. (If a fund has 100% turnover, the fund replaces all of its holdings over a 12-month period. This is known as Turnover Ratio.)
- The returns on these funds are mainly dependent on the fund manager’s ability to spot arbitrage opportunities. As more funds and more monies chase the arbitrage opportunities, the returns can reduce. Continuing with Idli example; If hotel customers realize that same quality idlis are available at Rs 5 in the near-by canteen, the profits made by Saravana will surely come down. (or) The canteen owner can increase the price of each Idly and the arbitrage opportunity can vanish from the market.
Do you invest in Arbitrage Funds? Do you believe that these are good substitutes for Fixed Deposits? Kindly share your views. Cheers!
(Image courtesy of Stuart Miles at FreeDigitalPhotos.net)
(Post Published on : 18-May-2016)