 "mutual funds")
Investors are back to arbitrage funds, pouring in as much as Rs 9,482.65 crore. The category performed well in July too, with an inflow of Rs 10,074.87 crore.
Bajaj Finserv has recently come out with an NFO too.
Such funds allocate a minimum 65% to equity and equity-related instruments through spot-future arbitrage. Hence, the taxation is as per equity funds.
The inflows in this category reflect high returns and better taxation treatment these funds offer compared to debt plans.
The arbitrage category is typically used by investors to park their short-term money. The category, during volatile markets, has the potential to garner a slightly higher return than the relatable fixed-income categories. Therefore, the quantum of both inflows as well as outflows is generally high during such periods.
How do they function?
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"Arbitrage Funds generate returns by exploiting mispriced opportunities between spot and futures prices in cash and derivative markets. Arbitrage opportunities can exist in the same stock between different exchanges or between a security and its futures price," said Melvyn Santarita of Morningstar India.
Santarita explains this with an example:
Suppose stock X is trading at Rs 100 on BSE and Rs 101 on NSE, the fund manager would simultaneously buy it on BSE and sell it on NSE at Rs 101, making a profit of Rs 1. Similarly, the fund manager can buy a stock at a spot price of Rs 1,000 in the cash market and simultaneously sell it at Rs 1,002 in the futures market, locking in a profit of Rs 2 over the duration of the contract.
Suppose stock X is trading at Rs 100 on BSE and Rs 101 on NSE, the fund manager would simultaneously buy it on BSE and sell it on NSE at Rs 101, making a profit of Rs 1. Similarly, the fund manager can buy a stock at a spot price of Rs 1,000 in the cash market and simultaneously sell it at Rs 1,002 in the futures market, locking in a profit of Rs 2 over the duration of the contract.
On the date of expiry, if the price differential between the spot and futures position of the subsequent month's maturity still exists, fund managers roll over the futures position and hold onto the position in the spot market.
By buying in the cash market and selling in the Futures and Options market, fund managers lock in profits irrespective of the price movement of the security.
In some instances, fund managers may unwind both the spot and the future position before the expiry of the current future to generate higher returns or to meet redemptions.
"The arbitrage rollover spread has been consistent for the last 7-8 months. The spread has been consistent in the range of 60-80 bps, which is very good in terms of other short-term parking opportunities. This category is being used by investors to park short-term money for 3-6 months and comes with the added advantage of lower taxes. So the flow is on the rise," said Mukesh Kochar, National Head – Wealth, AUM Capital.
Reasons for popularity decoded:
Arbitrage funds leverage the mispricing in equity shares in the spot and futures markets by simultaneously buying and selling cash market shares in futures or derivatives markets to earn the differential gain.
Better tax treatment than FDs:
"In August 2023, arbitrage funds received a robust inflow due to a better tax treatment than fixed deposits. Since arbitrage funds are treated as equity funds, they offer a massive tax advantage for an investor in the highest tax bracket. For such an investor, FD returns are taxed at 30 per cent vs only 15 per cent tax on arbitrage funds if redeemed within one year (short term) and 10% tax after one year (long term). So, if an investor earns Rs 1 lakh annual interest on an FD, her tax liability will be Rs 30,000. Compared to this, the investor needs to pay Rs 15,000 as short-term capital gains for selling his profits from an arbitrage fund and only Rs 10,000 if she sells the units after one year," explained Ajinkya Kulkarni, Co-Founder and CEO, of Wint Wealth.
Since arbitrage funds have shallow risk, they are better than liquid funds for parking funds required in the near future.
Arbitrage funds are less volatile than pure equity funds
Arbitrage funds tend to be less volatile than pure equity funds because they aim to generate returns by exploiting price differentials in the cash and derivatives segments of the stock market. "If you are expecting fixed returns without too many risks, you can opt for arbitrage funds but avoid putting all your funds into just one fund category," said Adhil Shetty, CEO, of Bankbazaar.com.
Since arbitrage funds profit on price differentials in different markets, it is ideal for investors who are looking for relatively safer options but at the same time are willing to invest in securities beyond debt.
“If an investor is in a high tax bracket, they can invest their surplus fund in arbitrage funds. These funds are taxed like equity where it is only a 15% tax if redeemed within 1 year and 10% tax if redeemed after one year. Arbitrage funds are very low risk, give better returns than most savings accounts and you also get effective lower tax rates on them," said Akshar Shah , founder, Fixed.
You should consider arbitrage funds as equivalent to liquid funds
When you invest in an arbitrage fund, you are considered you be investing in an equity fund. In the equity fund, the short-term capital gain is 15% and the long-term capital gain is 10% after adjusting Rs 1,00,000 of gain.
"Suppose I am investing in a debt fund where I am paying 30% taxation as per my tax bracket or 20% taxation. In the same way, we are paying only 10% in the long term and 15% in the short term in the case of an equity fund or an arbitrage fund. So tax advantages are there in the arbitrage fund.
The second thing is that an arbitrage fund doesn't carry any kind of a credit risk. Credit risk means that when we are buying a bond, there is always a chance that the bond may default because the arbitrage is the buying equity share in one exchange and selling it in another exchange. Obviously, it does not carry any kind of credit risk," said Soumya Sarkar, Co-Founder, of Wealth Redefine.
Due to the tax arbitrage funds are better positioned for high-net-worth individuals than liquid funds or liquid plus funds.
How to decide if arbitrage funds are for you?
On a pre-tax basis, arbitrage funds generally deliver slightly lower returns than liquid funds over any block of one year. "But because of their preferable tax treatment, they pip liquid funds on a post-tax basis for somebody in the highest tax bracket. This is because, in the case of liquid funds, the returns are taxed at 30 per cent for a holding period of less than three years, whereas arbitrage funds are able to fetch the preferential tax treatment like an equity fund. So, because of the lower tax liability, their post-tax returns end up being slightly higher. But remember, these funds also tend to be more volatile than liquid funds. So, if you're looking to invest for a time horizon of about a year or a year and a half, you may consider arbitrage funds given that you're in the highest tax bracket. But they may not be a very suitable option for your longer-term fixed-income allocation," said Ashutosh Gupta of Value Research in a note.
These funds are apt for those investors who are looking to have equity exposure but are worried about the risk associated with the same.
They are a safe option for risk-averse individuals to safely park their surplus funds when there is a persistent fluctuation in the market. Historically, arbitrage funds are known to offer returns in the range of 7% to 8% over one year but their five-year average has been between 5 and 5.7 per cent, which is even less than the inflation rate. Hence financial planners recommend arbitrage funds to investors for short-term needs of a month to six months, since they are likely to offer around 7% returns with better tax efficiency than liquid funds.
