Over the last year or so, returns from debt funds have been muted, particularly long portfolio maturity funds, as market movement has not been favourable. One positive fallout of this is that the accrual level in debt funds has improved.
As and when market prices of bonds fall and yield levels move up, the valuation yield moves up and the portfolio yield improves. That apart, investors are looking at last one year’s performance in debt funds and searching for substitutes. Herein comes the question, are arbitrage funds a substitute for debt funds.
Arbitrage funds earn returns from the price differential between equity shares in the 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 is deferring a transaction from the current date to the last Thursday of the month. For this deferment, some other trader is stepping in and conceptually ‘funding’ it. When a trader in the market is purchasing a stock in the stock futures market, the arbitrage fund manager is selling the stock at a price higher than the cash market, and this price differential represents the ‘cost of funding’.
Is it a ‘debt’ fund?
From a technical point of view, arbitrage funds have 65% or more of the portfolio in cash-futures arbitrage, and 35% or less in debt or money market instruments. However, from a practical perspective, these funds may be seen as fixed income funds, as there is no directional call on equities. Returns do not come from equity market 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 ‘sale’ position in the futures of the same stock. Returns may be volatile to an extent, but is 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. Long term capital gains (LTCG) tax for a holding period of more than one year is 10% (plus surcharge and cess as applicable), and dividend distribution tax (DDT) is applicable at the same rate. Short term capital gains (STCG) tax for a holding period of less than one year is 15% plus surcharge and cess. Given this taxation rate, let’s look at the break-even return for a DDT rate of 11.65%. Assuming a return of say 5.8% from arbitrage funds, the net of DDT return from arbitrage is 5.12%. In debt funds, the DDT rate for individuals is 29.1%. Hence to achieve a net return of 5.12%, the debt fund will have to deliver 7.22%, derived as 5.12% / (1%-29.1%). In the current situation, with the elevated yield levels of debt funds, achieving 7.5% over next one year looks like a sanguine possibility.
The argument in favour of arbitrage funds is that by virtue of the tax efficiency over debt funds, even relatively lower returns (pre-tax) makes it a viable proposition for fixed income investors. In periods of sub-optimal returns, like last year for debt funds, arbitrage funds look better. However, after the imposition of LTCG on equity funds, the tax advantage is relatively lower.
To be noted, performance of liquid funds is more stable than arbitrage funds and you can exit liquid funds anytime with linear returns. In the debt fund allocation, you may allocate some component to arbitrage funds, particularly in volatile periods. Otherwise, taxation per se should not be the investment criterion as tax laws are subject to change.