Arbitrage vs liquid funds: Why the former has become an investor darling

India's mutual fund industry  saw major net inflows in Arbitrage and broad-based equity funds in the second quarter of fiscal year 2024, revealed a study by  Motilal Oswal AMC recently. 

"At >80% of market share, Arbitrage & Broad Based categories took away the lion’s share of net inflows into Equity funds during July – September quarter," noted the study. Liquid & Overnight funds accounted for more than 90% of net outflows from Constant Maturity category, followed by Ultra Short & Short Duration funds. Most of these net outflows came during August and September.

Source: Motilal Oswal

Generally, investors use Debt funds with maturity up to 1 year to park excess cash in the short term, leading to high volatility in inward & outward flows. Low Duration & Money Market funds on the other hand, saw net inflows of Rs 11,000 crore  in aggregate.

 

The study shows Arbitrage funds are gaining popularity presumably as investors turned to Arbitrage funds as a more tax-efficient substitute to Liquid funds.

In fact these funds receiebed net inflows of nearly Rs 49,000 crore in just seven months (April 2023 to October 2023).

Blame it on debt funds losing indexation benefits 

Indexation reduces capital gains tax because it takes inflation into account. Value Research explains this with an example: 

Say, you invested Rs 2 lakh in April 2017. In 2023, the money increases to Rs 3 lakh. Without indexation, the gain of Rs 1 lakh would be added to your income and taxed accordingly. Assuming you are in the 30 per cent tax bracket, you would have to pay Rs 30,000 tax. But with indexation, your investment would be adjusted for inflation and then be taxed.

What's changed?
 

"Earlier, if you sold your debt fund within three years, the gain was added to your income and was taxed as per your slab. For investments beyond three years, it was taxed at 20 per cent after providing the benefit of indexation. According to the amended Finance Bill, the gains from mutual funds with less than 35 per cent equity exposure (effectively debt funds, gold funds and international funds) will not be subjected to indexation anymore. Instead, all the gains will get added to your income that year and be taxed at your tax slab," explained Sneha Suri of Value Research. 

Let's say you had invested Rs 5 lakh in a short-duration fund in 2019, and it gave you a return of 7 per cent per annum. After four years, your fund's worth would be about Rs 6.55 lakh. Under the new rules, a person in the 30 per cent tax bracket will end up paying about Rs 46,000 in taxes. But in the indexation era, the tax outgo (at 20 per cent) would have been around Rs 12,000 only - nearly Rs 34,000 less. Put simply, investors falling under the higher tax bracket now have to shell out higher taxes, explained Suri. 

And in the case of arbitrage funds, they are treated like equity-oriented funds, which enjoy superior taxation.

"With these funds, you end up paying a 15 per cent tax on short-term capital gains and a 10 per cent tax on long-term gains, only if they exceed a lakh of rupees in a financial year," said Ashish Menon of Value Research. 

From a tax perspective, arbitrage funds are a no brainer compared to liquid funds

 Arbitrage funds are taxed as equity and hence provide a lower tax rate of 15 per cent if sold within an year and 10% if sold after an year. Compared to that, Liquid funds are taxed at the slab rate which can be 30 per cent or even higher with surcharge. Even for corporates, the rate of taxation of arbitrage funds is lower," said  Ankit Jain, Partner, Ved Jain & Associates.

How to choose between arbitrage funds and liquid funds 

Liquid funds invest in highly rated short-term debt securities such as T-Bills and commercial papers. Arbitrage funds invest across debt, equity, and equity derivatives to leverage cash and futures market arbitrage opportunities while maintaining fully hedged positions. Therefore, both investments have similar returns and risk profiles. 

Arbitrage funds are meant for short-term investment with a minimum investment horizon of 3-6 months. These funds use the various arbitrage opportunities available in the market like cash-future arbitrage, dividend arbitrage etc. These funds do not keep any open position in equity and remain fully hedged with a view to making an absolute return out of the arbitrage opportunity for a given period of time, generally from expiry to expiry.

Liquid fund invests in money market instrument with a maturity of around 30 days and attracts full taxation as per slab. Liquid funds are meant for short-term parking of around 15-30 days. These funds are stable in nature as the modified duration is very low and hardly any credit calls.

" If someone is parking funds in liquid fund for 3 months or more then it makes sense for him to switch to arbitrage fund for a better post-tax return.

Investors should remember one important thing while investing or redeeming an arbitrage fund. The timing of entry or exit should be close to expiry. Entry and exit in between might yield an additional reward or might reduce the return depending on the arbitrage spread at that time. So for a retail investor, it is prudent to invest around expiry week which is the last week of the month, or close to expiry day which is the last Thursday of the last week of the month," said Mukesh Kochar, National Head of Wealth, AUM Capital.

Suppose an investor invests in a liquid fund and earns a 6.5% pre-tax return and falls in a bracket of 30% then the POAT tax return would be 4.50 per cent whereas a yield of 6.50 per cent pre-tax for an arbitrage fund will translate into a yield of 5.50 per cent post-tax.  Kochar has not included surcharge and cess for simplicity of calculation. So clearly  there is a better post-tax return in arbitrage fund.

The main difference between liquid and arbitrage funds is taxation, liquidity, and exit load

"As the name suggests, liquid funds provide high liquidity without an exit load. So, any redemption is processed on a T+1 basis, unlike T+3 days processing for arbitrage funds," said Ajinkya Kulkarni, Co-Founder and CEO, Wint Wealth
 Some arbitrage funds charge exit loads if the units are sold within 2-4 weeks.  Kulkarni explains this further:

To better illustrate, two individuals in the 30 per cent  tax bracket have invested Rs 10 lakh in an arbitrage fund and liquid fund, respectively. Let us further assume that within two weeks, they gain Rs 2000 as capital gain and interest, respectively. At this point, they have to sell the units due to some emergency.

The tax outgo of the first investor will be  Rs 300, i.e., 15 per cent  of Rs 2000 (short-term capital gain). Another Rs 20-25 would go towards exit load.

The second investor will have to shell out Rs 600 in tax, i.e., 30% of Rs 2000 (interest taxed at slab rate).

If both of them had held the units for a year, the actual returns on the arbitrage fund would be much higher. However, the investor in the liquid fund will receive the fund quicker than the arbitrage fund investor.        

"Both investment avenues have their pros and cons. Therefore, one must choose liquid funds if the need is higher liquidity. But if the investor needs some additional returns through a better taxation structure, and can afford a couple of additional days for liquidity, arbitrage funds are a better choice," said Kulkarni.


How arbitrage funds make money 


"Arbitrage funds invest in arbitrage opportunities. For instance, if the shares of a company trade at Rs 100 on NSE and Rs 105 on BSE, the fund would buy the stock at NSE and sell it at BSE for a profit of Rs 5. Similarly, there can be a price difference between the cash and derivatives markets. Let's say a company's share price is Rs 104 in the cash market, and its Futures contract trades at Rs 115; the fund would buy the shares and sell the Futures. Since they are less volatile compared to a to a regular equity fund, a lot of investors are parking their emergency money in them instead of liquid funds," said Value Research's Menon.


When arbitrage funds work well 


Kaustubh Belapurkar, director - manager research, Morningstar India believes the arbitrage funds have pre-tax returns similar or marginally better than Fixed Income funds at the shortest end of the curve and are best suited for 6-12 months of investment horizon. Such funds work best when:

1. Arbitrage funds work well in volatile or bullish markets when stock futures are trading at a premium.
2. Arbitrage funds don’t work well in markets where futures are trading at a discount or future premiums are narrow due to excess money chasing arbitrage opportunities.
3. Important to keep at least a 6 month investment horizon as returns could be unpredictable in the short term. 

Returns  (Absolute returns for <1 yr, CAGR for greater than 1 year)

Source: Morningstar

TheArbitrage  funds suit those who have a sizable amount of idle money and fall in the 30 per cent tax bracket,

Value Research makes the investmen case for arbitrage funds with the following table :

"Note: Average 1-year rolling returns of the respective category averages have been used. In case of long-term gains, it is assumed there are no other gains to be adjusted against the Rs 1 lakh limit," said Menon.

Source: Value Research 
 

Menon's advice: If you don't have a sizable amount of idle money, and nor do you fall in the 30 per cent tax bracket, your money can seek refuge in a liquid fund.