Arbitrage funds can replace money market funds but not liquid funds.

Arbitrage funds are often compared with liquid funds to park short term money. In fact, many MFDs recommend arbitrage funds as a substitute for liquid fund largely due to perceived less volatility, similar returns and additional tax benefits.

Considering the change in interest rate scenario, it is time to revisit both the categories. Let us look at it.

Tax efficiency

Arbitrage funds enjoy equity fund taxation and hence, are more tax efficient compared to debt funds.

In equity funds, while the short-term capital gains tax is 15%, long term capital gains is taxed at 10%. There is no LTCG on gains of up to Rs.1 lakh. LTCG is applicable after 12 months. The Income-Distribution-cum-Capital-Withdrawal (IDCW) option in equity funds is not lucrative as it is taxable in the hands of the investor at the slab rate.

On the other hand, LTCG is applicable after 36 months in debt funds. Liquid funds are largely held for short term, hence, gains from liquid funds are taxed at slab rate if redeemed before 36 months.

Can arbitrage funds be good substitute for liquid fund?

No. debt funds earn returns from accruals, which is the coupon or interest on securities. There is no such coupon in arbitrage funds.

Fund manager of arbitrage funds seek opportunities in price variations of equities across markets (spot and future).

For instance, let’s say a particular stock trades at Rs.98 and Rs.100 in spot and future market, respectively. The fund manager would buy stock from the spot market and will simultaneously short position by selling the stock at Rs.100 on expiry making a risk-free return of Rs.2.

However, at times, the spread between the spot and future markets is marginal. As per regulations, an arbitrage fund has to have at least 65% in equity arbitrage. That is, they cannot shift to a debt-only portfolio to protect returns.

So how to overcome this issue? You can simply hold arbitrage funds for at least six months or preferably a year. This gives fund managers an opportunity to play different market cycles at attractive spread.

Hence, arbitrage funds are not liquid fund substitutes. It may be a substitute for money market funds, which have portfolio maturity up to one year.   

Conclusion

Let us look at the net-of-tax returns or break-even for arbitrage and debt funds. Assuming a holding period of more than one year and tax rate of 10% (ignoring surcharge and cess), a return of say 5.75% in arbitrage funds indicate net of tax return of 5.18%. However, debt funds have to generate 7.39% to generate similar net returns. Overall, MFDs should look at arbitrage funds as an attractive substitute for money market funds.

Source: https://cafemutual.com/news/guestcolumn/27731-arbitrage-fund-cant-be-a-substitute-for-liquid-fund