Can Arbitrage Fund replace Debt Funds in Your Portfolio?

Debt Funds Vs Arbitrage Fund Vs  Fixed Deposits

Debt Funds Vs Arbitrage Fund Vs Fixed Deposits

With the recent proposed change in taxation of the Debt Mutual Funds in Budget 2014, it has lost the tax advantage that it once enjoyed over fixed deposits.

So the question is – is there a financial instrument whose risk and returns are similar to Debt Funds but still enjoys lower taxation?
The answer lies in exploring a not so well known category of Mutual Funds known as Arbitrage mutual Funds.

What are Arbitrage Mutual Funds?

Arbitrage mutual funds are special type of equity mutual funds which generates returns based on arbitrage opportunities available in stock market. Most funds encash the arbitrage opportunities due to price difference of a stock in cash and derivatives market.

Example:

Suppose ICICI bank is trading at Rs 1,475 in cash market and Rs 1,500 in futures market. The fund would buy at Rs 1,475 in cash market and sell same number of shares in futures at Rs 1,500. Now on last Thursday of the month (which is the settlement date for futures) the prices of future and cash market converge.

There could be two situations on Thursday:

1. The stock price of ICICI Bank moves to Rs 1,600:
The fund would gain Rs 125 (1600-1475) in cash market while it would lose Rs 100 (1600-1500) in futures market. The net gain would be Rs 25 with the overall transaction.

2. The stock price of ICICI Bank crashes to Rs 1,400:
In this case the fund would lose Rs 75 (1475-1400) in cash market while it would gain Rs 100 (1500-1400) in futures market. Again the net gain is Rs 25.

So as you can see in this arbitrage opportunity the fund would make Rs 25 irrespective of the movement of stock price.

There could be other situations which can give rise to such opportunities:

  1. A stock price quoting differently in two exchanges (rare but can happen at times). In this case fund buys from one exchange and sells in other making small profit.
  2. Such arbitrage opportunities also arise at the time of merger or acquisition of companies.

As you can see in above examples, the investment strategy followed by arbitrage Funds make them Low risk (even though they are dealing with equities and derivatives which in itself are very high risk).

Limitations of Arbitrage Funds:

The concept of arbitrage funds look good but with high computing power and well developed algorithms, the arbitrage opportunities are limited and hence limiting their returns. These funds work well in volatile market conditions but when the markets are going in one direction, the performance suffers.

Tax/TDS on Arbitrage Funds:

If the Arbitrage Funds have minimum 65% of their corpus invested in equities and derivatives they are treated as equity funds for taxation purpose. Fortunately most of funds follow this 65% rule.

If the fund is redeemed within 1 year of investment, the gains are treated as Short Term Capital Gains. This gain is taxed at 15% + 3% education cess (15.45%).

If the fund is redeemed after 1 year, the gains are treated as Long Term Capital Gains and the good news is – there is no tax on Long Term Capital Gains for equity funds!

There is no TDS for Arbitrage Funds.

Considerations while investing in Arbitrage Funds:

Following are some of the points to keep in mind while investing in Arbitrage Funds:

  1. Redeem your funds on last Thursday of the month – there is no restriction on when you can withdraw your funds but as the derivatives settlement happen on last Thursday of the month, it’s good to redeem on that day.
  2. Consider Exit loads – Some finds have exit loads in the range of 0.25% to 1% if the exit is between 30 days to 6 months. Keep in mind your investment time frame while choosing the fund.
  3. Taxation – the real tax benefit on arbitrage fund is realized when you are invested for more than a year. So plan accordingly.
  4. Not for long very long term – these funds are meant for parking short term money i.e. mainly for 1 -3 years’ time frame. For longer duration you should either look for equity funds or debt funds.
  5. Go direct – The expense ratio difference between Direct and regular funds vary between 0.3% to 0.5%. so choosing “Direct” option would increase your return by 0.5%
  6. No assured return – the returns from arbitrage funds are close to that of fixed deposits but there is no assurance of the same. It may vary widely at times.
  7. Some Risk is involved – there have been cases where arbitrage funds have given minor negative returns in a quarter. So these funds are not suited for parking very short term money.

Return Comparison for FD, Debt Fund and Arbitrage Funds:

Below is the table showing the average annual returns of Fixed Deposit from SBI (1 -2 Years duration), Ultra Short term Debt Funds and Arbitrage Funds over the years

Comparing Returns of Fixed Deposit Vs Debt Funds Vs Arbitrage Funds

Comparing Returns of Fixed Deposit Vs Debt Funds Vs Arbitrage Funds

As can be seen, out of 9 years, Arbitrage Funds outperform in 8 years when taxation is taken into consideration.

Conclusion:

With favorable tax treatment and at par returns with Fixed deposits, arbitrage funds seems to be a good option to park money for 1 to 3 years time frame. These funds suit people who are in higher tax slabs. For lower tax slabs and for shorter duration (of less than 6 months) I would still recommend Fixed Deposits where there is almost no risk and the returns are assured.

3 thoughts on “Can Arbitrage Fund replace Debt Funds in Your Portfolio?

  1. Hi Amit,
    what is the monthly interest rate I will gain if I deposit 20 lakhs in a FD at SBI today

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