Arbitrage funds in the mutual fund space are benefiting from the widening spread between the cash and stock futures segment, providing tax advantages for investors.
The prevalent discussions and debates in the mutual fund space have been about mid- and small-cap valuations, loss of tax advantage for debt funds, SIP (systematic investment plan) mobilizations, new folios and the like. Apart from these, a development happening in recent times is that in the equity market, the spread between the cash or spot segment and the stock futures segment has widened. In a volatile non-trended market, this spread tends to move up. This essentially being the cost of carrying a trade till the expiry of the futures contract, in a non-trended market, the uncertainty pushes it up.
The mutual fund category that benefits from cash-futures spread is arbitrage funds. A majority of 65% or more of the portfolio of arbitrage funds is invested in this. The balance 35% of the portfolio is invested in debt or money market instruments. For fund categorization purposes and tax purposes, arbitrage funds are equity funds. However, there is no directional call on equities, implying that returns from arbitrage funds do not depend on equity stock prices going up. The spread on the day of taking a portfolio position in cash market, and contra position in stock futures market, is locked in, one month at a time.
The advantage of arbitrage funds, from the investors’ perspective, is taxation. In the growth option of the fund, for a holding period of less than one year, tax rate on the returns is 15% plus surcharge and cess. If you hold it for more than one year, the tax rate is even lower, 10% plus surcharge and cess. The differential in net-of-tax returns with debt funds has become even more pronounced since the indexation benefit has been taken away from debt funds.
Let us take an illustration. Let us say, returns from a debt fund is 7%. We will take the tax rate at 30%, assuming highest tax bracket, ignoring surcharge and cess for simplicity. The net of tax return from the debt fund will be 4.9%. Given the tax advantage, over a holding period of less than one year, if the arbitrage fund yields a return of even, say, 5.77% the net of tax return is 4.9%. This is about the break-even rate of return, for comparison with debt funds. As long as the arbitrage fund is yielding the same return, 7% in our example, your net-of-tax return is 5.95% for a holding period of less than one year. If you hold it for more than one year, net of tax at 10%, your return is 6.3%. Though for classification purposes, arbitrage funds are equity funds, functionally, these are comparable to debt funds. There is no directional call on equities, the cash-futures spread is locked in, one month at a time. For 35% of the portfolio, it is debt and money market instruments.
Given that arbitrage fund performance has picked up, due to the reasons mentioned above, you may benefit from it, in the non-equity component of your portfolio. There are some caveats though. The intended time horizon should be six months or longer. This is due to volatility. The cash-futures spread may shrink under certain market conditions and there may be adverse mark-to-market consequences. To tide over these situations, you need not do anything specific, you just have to give it more time. Ideally, your horizon should be one year to take care of any interim volatility, or at least six months.
They are not liquid fund substitutes because liquid funds are meant for parking purposes, even for a horizon of one week. Opt for the growth option, because, in the dividend option, now known as income distribution cum capital withdrawal option, it is taxable in your hands at your marginal rate of tax, usually 30% plus surcharge and cess.
Conclusion
In your overall portfolio allocation, equity provides the growth component and debt provides stability and funds for short-horizon cash flow planning. In the debt component, a part may be allocated to arbitrage funds, to take advantage of taxation and performance, as long as performance is higher than the break-even with debt mentioned above. However, the entire debt component should not be allocated here. Diversification is a basic tenet of investment. Even arbitrage funds can be volatile, where debt funds will provide the diversification and stability.