Over the last one year, most debt funds have delivered suboptimal returns, particularly liquid funds and funds with long portfolio maturity largely due to market conditions.
This has led many investors to look at substitutes for liquid funds to park money for short term. Since most advisors recommend arbitrage funds to investors for short-term needs, a question arises whether arbitrage funds are a better substitute for liquid funds.
But first, let us take a look at arbitrage funds. Arbitrage funds earn returns from the price differential of shares between cash market and futures market. Typically, the price at which a stock is sold in the stock futures market is higher than the price at which it is purchased in the cash or spot market. The price difference represents the ‘cost of funds’ for the remaining number of days between the date of transaction and ‘expiry’, which is the last working Thursday of the month. The concept of ‘cost of funds’ is that a trader or investor defers his transaction from the current date to the last Thursday of the month.
Because of this deferment, other traders step in and conceptually ‘fund’ it. When a trader in the market purchases a stock in the stock futures market, the fund manager sells the stock at a price higher than the cash market and this price differential represents the ‘cost of funding’.
Is this strategy safe?
From a technical point of view, arbitrage funds have exposure of at least 65% in cash-futures arbitrage and a maximum of 35% in debt or money market instruments. From a practical perspective, you can say arbitrage fund a fixed income fund as there is no directional call on equities. Simply put, in arbitrage funds, fund managers do not generate returns from equity markets moving up but from the price differential between the two segments of the market. Every ‘buy’ position in an equity stock is offset with a ‘sell’ position in the futures of the same stock. Returns may be volatile to an extent but are stable enough to be compared with fixed income funds.
Arbitrage funds are technically equity funds and enjoy the tax efficiency of equity funds over debt funds.
While the LTCG tax in growth option of arbitrage funds is taxed at 10% after the gain of Rs.1 lakh, dividends from arbitrage funds are subject to DDT of 10%. Similarly, STCG tax for a holding period of less than 1 year is 15%.
As most investors in this segment invest in dividend option of arbitrage funds, the effective dividend distribution tax (DDT) in arbitrage fund is 11.65% including surcharge and cess. Assuming CAGR of say 5.8% from arbitrage funds, the net return from arbitrage would be 5.12% after factoring in DDT. In debt funds, the DDT rate for individuals is 29.1%. Hence to achieve a net return of 5.12%, the liquid fund will have to deliver 7.22%.
In the current situation, with the elevated yield levels of debt funds, achieving 7.22% over next one year looks difficult.
Considering its tax efficiency, arbitrage funds score over fixed income funds i.e. even if arbitrage funds generate lower returns, these funds still make sense for fixed income investors. However, performance of liquid funds is more stable than arbitrage funds and you can exit liquid funds anytime with linear returns.
In my view, advisors can recommend their clients to put some portion of fixed income exposure to arbitrage funds particularly in volatile market condition. But remember, taxation laws are subject to change.