What Are Arbitrage Funds And How They Have An Edge Over Debt Funds
Oct 25, 2017

Author: PersonalFN Content & Research Team

Over past few months, most major banks cut their Savings Bank interest rates In some cases, the savings interest that you earn may be as low as 3%-3.5% per annum (p.a.). Interest rates offered by major banks on 1-year fixed deposits too, have dropped to as low as 6.25%. In such low interest rate regimes, Indian savers are scurrying for better income generating options.

Debt mutual fund schemes were often touted as an ideal alternative. However , post Budget 2014-15, which changed the taxation policy for non-equity schemes, debt mutual funds took a back seat for short-term investments.

Under the present tax rules, gains on units of non-equity schemes redeemed before the completion of 36 months is considered as Short-term Capital Gains (STCG). These gains are added to your income and taxed accordingly. Therefore, if you fall in the highest tax bracket, the tax liability can go up to 35.54% (30% tax plus 15% surcharge and 3% cess). Long Term Capital Gains in case of debt mutual funds are taxed at 20% with indexation (23.69% including surcharge and cess).

Therefore, for persons looking for short-term investment avenues, a tax of nearly 36% is a high price to pay. Thus, a better alternative to debt funds is ‘Arbitrage Funds’.

Arbitrage Funds are categorised as equity oriented schemes, hence, gains on units held for over a year are tax-free. Tax on Short Term Capital Gains on units held for less than a year is 15%, excluding surcharge and cess.

Thus, arbitrage schemes provide low-risk and short-term investors a huge tax advantage.

But are the returns of arbitrage funds any better than short-term debt schemes or liquid funds?

Before we delve into the performance of arbitrage schemes, let’s first understand how arbitrage schemes work.

How do Arbitrage Funds Work?

The term ‘Arbitrage’ refers to the simultaneously buying and selling of a security in two different markets, with an aim to gain from the price difference. Since, the transactions are in either direction, the positions are completely hedged. Hence, arbitrage transactions are virtually risk-free.

Arbitrage funds are a category of mutual funds that endeavour to take advantage of mispricing of stocks (or a stock index) in different market segments. However, these are short-term opportunities that spring up due to lack of information to a set of market participants in one of the markets.

The cash market is , normally, a market where investors buy securities to receive delivery and settle the trade by paying for their purchase. Now in the case of derivatives market, especially in 'futures'. This is where there is no immediate delivery of security, but the contract is entered to buy / sell security at a future date.

On several occasions, same asset is traded at different prices in different segments and/or different markets, which results in an arbitrage. The investor has to pay only a certain percentage of the total contract value upfront; which is called margin money.

The fund manager of the arbitrage fund will evaluate the difference between the price of a stock in the futures market and in the spot market. If the price of a stock in the futures market is higher than in the spot market, after adjusting the costs and taxes, the fund manager will buy the stock in the spot market and sell the same stock in equal quantity in the futures market, simultaneously.

Here’s an example to understand this better.

Let’s assume on December 15, 2016, the arbitrage fund buys 10,000 shares of Infosys on spot @ Rs 990 and at the same time sells 10,000 Infosys futures for December 2016 expiry @ Rs 995. By doing this, the fund manager locks in a selling price for the stock at Rs 995, while he bought the stock in the cash market for Rs 990. The scheme thus enters into a fully hedged transaction by selling the equity position in the futures market for expiry on say December 25, 2016. If the scheme holds this position till expiry of the futures, the scheme earns an absolute return of 0.51% or 18% annualised, irrespective of what is the price of Infosys is on the date of expiry.

On the date of expiry, if the fund manager finds the difference in the spot price and futures price of the subsequent month attractive, he may ‘rollover’ the futures position, while continuing to hold the stock in the spot market. Thus, the fund manager will unwind the short position in the futures of the current month and simultaneously short futures of the subsequent month maturity, and hold onto the spot position. In case such an opportunity is not available, the scheme would liquidate the spot position and settle the futures position simultaneously.

However, there is a risk in the event the arbitrage fund may have to liquidate the investment before expiry. It could be due to redemption pressures or other factors. In the above example, if the spot is sold at Rs 990 and the futures are bought at Rs 996, then there would be negative returns on the trade. If the spot is sold at Rs 990 and the futures are bought at Rs 994, then there would be positive returns from the trade.

An arbitrage fund may also build market neutral positions that offer an arbitrage potential, for e.g. buying the basket of index constituents in the cash segment and selling the index futures, Buying ADR/GDR and selling the corresponding stock future, etc. It may also avail of opportunities between one futures contract and another. While we can delve deeper into the maths, it is a bit too complex for the average investor to understand.

How have Arbitrage Funds Performed?

If you look at the returns of arbitrage funds, they don’t seem very attractive when compared to the pre-tax returns of liquid funds or short-term debt funds. However, it’s the tax implication that makes the difference.

When considering the 1-year returns, the gains on arbitrage funds are tax-free. However, returns on liquid funds and short-term debt funds attract a tax rate of nearly 36% if you fall in the highest tax bracket.

Check out the performance in the table below:

1-year Return (%) as on:
30-Sep-11 30-Sep-12 30-Sep-13 30-Sep-14 30-Sep-15 30-Sep-16 30-Sep-17
Average Return of Arbitrage Funds 8.20 9.31 8.70 8.77 7.99 6.40 5.97
Crisil Liquid Fund Index (Post-tax) 5.01 5.59 5.51 6.11 5.52 4.95 4.32
Crisil Short Term Bond Fund Index (Post-tax) 4.39 5.93 4.98 6.52 6.38 6.01 4.90
Crisil Liquid Fund Index (Pre-tax) 7.77 8.67 8.54 9.49 8.56 7.67 6.70
Crisil Short Term Bond Fund Index (Pre-tax) 6.81 9.21 7.73 10.12 9.90 9.32 7.60
Data as on September 30, 2017. Returns are absolute. Tax @35.54% considered.
(Source: ACE MF, PersonalFN Research)

As can be seen above, in most of the periods, Arbitrage Schemes outdid the debt fund benchmarks, if we consider the taxability as per the current rules. Thus, for short-term investments, arbitrage schemes are a clear winner.

For investments greater than three years, indexation kicks in. Thus, the effective tax rate would be lower than 20%. Hence, debt schemes may be able to deliver a better post-tax return as compared to arbitrage schemes.

Let’s take a look at the chart below, if debt schemes were, in fact, able to do better than arbitrage funds over long-term periods.

3-year Return (%) as on:
30-Sep-11 30-Sep-12 30-Sep-13 30-Sep-14 30-Sep-15 30-Sep-16 30-Sep-17
Average Return of Arbitrage Funds 6.14 7.08 8.56 8.76 8.21 7.77 6.80
Crisil Liquid Fund Index (Post-tax) 6.21 6.81 8.33 8.90 8.73 8.03 6.86
Crisil Short Term Bond Fund Index (Post-tax) 7.37 6.97 7.91 9.01 9.02 8.96 7.85
Crisil Liquid Fund Index (Pre-tax) 6.21 6.81 8.33 8.90 8.86 8.57 7.64
Crisil Short Term Bond Fund Index (Pre-tax) 7.37 6.97 7.91 9.01 9.24 9.77 8.92
Data as on September 30, 2017. Returns are absolute. Tax @23.69% (including surcharge & cess), with indexation.
(Source: ACE MF, PersonalFN Research)

On considering the past three-year returns on a yearly basis, we can see that debt fund indices have clearly outperformed the average arbitrage fund. Individual debt schemes would have performed much better. However, in a couple of three-year periods ending September 2012 and September 2013, arbitrage schemes performed marginally better than their debt fund counterparts.

From the above analysis, we can say that arbitrage schemes are an apt choice if your holding period is less than three years. The difference in taxation makes a significant transformation in the net returns.

Like with all investment avenues, you need to choose wisely.

Be cautious of Arbitrage Funds with unhedged equity allocation

As arbitrage schemes began gaining traction, fund houses were soon to capitalise on the trend and launched a modified form of arbitrage funds. These funds, also known as Equity Savings Funds or in some cases Enhanced Arbitrage Funds, included an unhedged equity exposure.

Equity Savings Funds are comparable to Monthly Income Plans that have a small equity component of 10%-20%. However, as Equity Savings Funds invest in equity Arbitrage opportunities instead of debt, they are treated as equity schemes and enjoy tax advantage.

However, due to the unhedged equity exposure, the risk involved is higher than pure arbitrage schemes. Hence, returns will be volatile. Risk averse or conservative investors seeking steady returns should ideally stay away from such schemes.

To conclude…

Ensure to assess your liquidity needs and tax liability before allocating money to liquid funds, short-term debt funds or arbitrage funds. For immediate liquidity needs, a savings bank account remains unmatched. However, for parking money for a few month or more, you need to consider other avenues due to the low interest rates and tax liability.

Arbitrage schemes are the most tax-efficient, though returns will depend on market conditions and the fund manager’s ability to reap rewards from arbitrage opportunities. However, on checking the past performance of these schemes, the short-term post–tax returns are decent when compared to debt investments, which can attract a considerably high tax rate.

A liquid fund , ultra short-term debt fund and short-term debt fund may turn out to be more tax-efficient than a savings account and even more liquid than a bank fixed deposit, especially if you are setting aside money for a contingency. These funds earn a higher return and are less volatile. Under the instant redemption facility, available for certain liquid schemes, it takes under 30 minutes to transfer the redemption amount to your bank account.

Prudent investing and financial discipline are vital ingredients for long-term financial well-being.

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