Use arbitrage funds to park short-term money

They could offer better post-tax returns than liquid funds and fixed deposits to those in higher tax brackets

Arbitrage funds are gaining in popularity among investors, as is evident from the growing assets under management (AUM) of this category. Seventeen funds had a cumulative AUM of Rs 43,651 crore at the end of August, an increase of 36 per cent over a year. In a declining interest rate environment, knowledgeable retail investors might consider investing in these.  

The primary reason for their popularity is the change in taxation rules of debt funds introduced in Union Budget 2014, which made these eligible for the indexation benefit after three years, instead of one. “Currently, the returns from liquid funds are taxable at the marginal income tax rate if you have held these for less than three years. In arbitrage funds, you can earn a return of 5.5-6.5 per cent with a high degree of consistency and without taking too much risk. You also enjoy equity-like taxation. The post-tax returns of these funds are attractive,” says Radhika Gupta, chief executive officer, Edelweiss Mutual Fund. Capital gains of equity funds are tax-free after one year, as is the dividend paid.

These funds carry a low level of risk. And, when there is uncertainty in market conditions, as now, they do prove handy. “Arbitrage funds hedge their entire equity exposure. So, you are not likely to experience downside risk,” says Vidya Bala, head of research, Fundsindia.com. Fund managers buy a stock in the cash segment and simultaneously sell its one-month futures contract, thereby locking in the spread at the start of the month. Hence, adverse market movements do not affect returns.

Three years ago, the average return of the category was around nine per cent. Returns have come down to 4.92-6.24 per cent for regular plans and 5.65-7.09 per cent for direct plans for the trailing one year. One reason is that the spread between cash and futures market closely tracks short-term interest rates. With interest rates coming down, returns from arbitrage funds have fallen. Moreover, 30-35 per cent of their portfolio is in short-term debt securities, whose returns have also been affected by falling interest rates.

The growing AUM of this category could also affect returns in the future. “Returns will be a function of the arbitrage opportunities available in the market versus the money chasing them. If the opportunities remain limited, while the amount of money chasing them grows, returns could get affected,” says Bala.

However, these funds will continue to be attractive so long as they beat the returns from liquid funds and short-term fixed deposits on a post-tax basis.

Retail investors looking to build wealth over the long term should avoid this category. “These funds are for investors who understand the concept of arbitrage, want tax efficiency and are looking to park money for nine months to one year,” says Bala. According to Gupta, investors could also go for the dividend option of these funds.

The ability to contain downside risk should be your key selection criterion in choosing a fund. “Look at the rolling one-month return in the past. The fund should not have experienced negative returns,” says Bala. Also, opt for purely arbitrage funds. Avoid enhanced arbitrage funds, which try to augment returns by investing in unhedged equities. Doing so raises a portfolio’s risk profile. The fund should also not carry duration risk in the debt portion. Go with a fund that has a low expense ratio. Finally, opt for direct plans whose average return is about 63 basis points higher than those of regular plans.