Should You Consider Arbitrage Funds After Change in Debt Mutual Fund Taxation

The Finance Bill 2023 amended the debt mutual fund taxation rule by removing the indexation benefit in case of long term capital gains on these funds. This rule applies to all mutual fund schemes, including Gold Funds and International Funds, that invest less than 35% of their assets in domestic equities. As a result, if you fall under the highest tax bracket, debt mutual funds are no longer tax-efficient than Bank FDs.

Does this mean you should look at alternatives to debt mutual funds, such as Arbitrage Funds?

First, let us understand what are Arbitrage Funds...

The Securities and Exchange Board of India (SEBI) defines Arbitrage Funds as mutual fund schemes following arbitrage strategy and investing a minimum of 65% of its total assets in equity and equity-related instruments.

Arbitrage Funds are equity-oriented hybrid mutual funds that aim to leverage arbitrage opportunities in the market. These funds invest a minimum of 65% of the corpus in equity and the balance 35% in debt and cash instruments. Arbitrage Funds take full-hedged equity positions to take advantage of the price difference (spread) between the spot and future market.

Arbitrage Funds vs Liquid Funds

Investors often substitute Arbitrage Funds as an alternative to debt mutual funds, particularly Liquid Funds, to park their short-term money as they are less risky compared to unhedged equity funds and can potentially generate better returns than some debt funds.

Moreover, Arbitrage Funds offer better tax efficiency compared to debt mutual funds. Here is how Arbitrage Funds are taxed:

Since Arbitrage Funds maintain a minimum of 65% equity allocation, they follow equity taxation. The long-term holding period for Arbitrage Funds is typically 12 months.

• If you redeem your Arbitrage Fund units before 12 months, you are liable to pay a Short-Term Capital Gains tax (STCG) at the rate of 15%.

• If you redeem from Arbitrage Funds after 12 months, but your capital gains are less than Rs 1 lakh in a financial year, then your Long Term Capital Gains (LTCG) are exempt from tax.

• If you redeem from Arbitrage Funds after 12 months and your Long Term Capital Gains are more than Rs 1 Lakh in a financial year, then you are liable to pay LTCG tax at the rate of 10% on the excess gains.

On the other hand, with effect from April 01, 2023, gains on debt mutual funds, whether short term (holding period less than 36 months) or long term (holding period more than 36 months), are taxed as per the income tax rate applicable to your income.

[Read: 3-Tiered Taxation of Mutual Funds: Here's All You Need to Know]

Should you consider Arbitrage Funds over debt mutual funds after change in taxation rules?

Though Arbitrage Funds carry lower risk compared to other equity-oriented funds and enjoy better tax efficiency compared to debt mutual funds. However, just like any other investment, they cannot be considered risk-free.

The performance of Arbitrage Funds depends on the availability of arbitrage opportunities. Generally, Arbitrage Funds tend to do well during periods of heightened volatility and uncertainty. And since arbitrage opportunities are not always available, Arbitrage Funds may be subject to heavy portfolio churning and volatility. Higher transactional costs can increase their expense ratios substantially.

Going forward, if there are fewer opportunities (spreads are lower) or if the fund manager fails to timely identify attractive opportunities, Arbitrage Funds may fail to generate attractive returns. Thus, Arbitrage Funds are suitable for investors who are looking for equity exposure at low risk and have an investment horizon of at least 6 months to a year to ride the different market phases and benefit from attractive spreads.

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On the contrary, debt mutual funds returns are expected to improve as we near the end of the rate hike cycle. Debt mutual funds, especially short-term debt funds, tend to be more stable and can generate decent returns at relatively lower risk.

Debt mutual funds also offer better liquidity. In the case of Liquid Funds can instantly withdraw their funds within a couple of hours. This is especially helpful if you have a very short term investment horizon of a few days to weeks.

Thus, if you are an investor with a low to moderate risk appetite, you should consider investing in debt mutual funds instead of Arbitrage Funds. With debt mutual funds, you can create a suitable portfolio comprising of schemes spread across various maturities and credit profiles to mitigate the impact of interest rate risk and credit risk.

You can consider allocating some portion in Arbitrage Funds if you are willing to take some risks for slightly higher returns. Investors under the highest tax bracket are likely to benefit from better tax efficiency by investing in Arbitrage Funds.