Market reaching new highs these days and in between random dips are the situation of wary among investors. In such fluctuations an investor should look at diversifying his/her portfolio into safe asset class which is at least protected from any adverse situation where he/she needs money for some short term requirement. Anyways, the thumb rule of any asset allocation or right financial planning says, you should not expose 100% towards equity if you foresee any emergency requirements. Even at the same time, not to be complete pessimistic and put all your monies in low risk/low yield asset class and miss out the opportunities of higher potential growth.
Until announcement of budget 2014-15, non-equity MFs (Debt schemes, Liquid Funds, FMP/FTPs etc) were the best bet apart from bank FDs. They were giving better post tax yield if held for more than 1 years due to benefits of indexation, but the new rules for non-equity towards taxation came as a body blow. Now this is clear that, any profit getting realised out of non-equity schemes will have tax as per individual’s tax slab, that means there is no difference between holding FDs and non-equity schemes upto 3 years if they have same returns. But it is different thing that short term gains from these funds can be off-set against losses from any other eligible capital asset which FD doesn’t have.
With such discouraging factors (it’s only the taxation), investors are looking at new avenues which could be considered as a next best alternative with decent post tax yield. Now Arbitrage Mutual Funds have suddenly become the flavor of the season. This is a type of equity mutual fund which tries to take advantage of the price differential (of the same asset) between two or more markets or market segments. These funds claim to have the potential to deliver better post-tax returns at a similar level of risk compared to debt funds (money market/liquid funds). Let us understand more about such schemes, their returns and risk factors along with taxations.
How Does Arbitrage Fund Work
Arbitrage funds exploit the difference in the price of a stock between cash and derivatives markets or even different stock exchanges such as BSE and NSE. For example, the price of a stock quotes at Rs 100 in cash market and Rs 102 in futures market. The fund manager would buy in cash market and simultaneously sell in futures market to lock in a profit of Rs 2 per share.
Arbitrage funds work well in volatile markets as fund managers are able to capitalize on differences in prices of a stock between the equity market and the futures market. Arbitrage fund managers reduce the risk in equities by hedging them using derivatives. Such funds also deploy surplus cash in debt securities and money market instruments.
Few Names of Arbitrage Schemes and their Objectives for your reference
Axis Enhanced Arbitrage Fund: The scheme aims to generate income through low volatility absolute return strategies that take advantage of opportunities in the cash and the derivative segments of the equity markets including the arbitrage opportunities available within the derivative segment, by using other derivative based strategies and by investing the balance in debt and money market instruments.
Birla Sun Life Enhanced Arbitrage Fund: The Scheme seeks to generate income by investing predominantly in equity and equity related instruments. It intends to take advantage from the price differentials / mis-pricing prevailing for stock / index in various market segments (Cash & Future).
ICICI Prudential Blended Plan – Plan A: The scheme aims to generate income through arbitrage opportunities emerging out of mis-pricing between the cash market and the derivatives market and through the deployment of surplus cash in fixed income instruments.
Most of arbitrage funds have been categories under Arbitrage – Hybrid basis their objectives and portfolio asset allocations.
Such schemes are not new, but basis current market scenarios and of course change in investors taste (who always demand; give me something new 🙂 ), most of fund houses have started coming up with NFOs now a days or recommendations to invest in existing schemes. I am sure, you have been getting pushes from your relationship manger, wealth manger or broker to invest in these.
Performances of few existing schemes are;
Taxation of Arbitrage Funds
Arbitrage funds are categorised as equity funds from a taxation perspective. This gives arbitrage funds the benefit of zero taxes on long-term gains (holding period of more than a year). If the holding period is less than a year, capital gains (short-term) are taxed at 15 per cent plus applicable cess.
When risk is already depicted between High/Average (not Low), then how much worth it is to get approx. 9% returns over 1 years. This doesn’t throw a competitive result between risk and reward ratios. So an investor who understands technicalities of equity investments will certainly stay away from this. Just for the sake of short term emergency fund planning, it would not be a good idea to risk your principal in short run because when unforeseen contingencies are concerns returns are immaterial (I believe) and in that case one should look at sufficient cash position, FD balance or to some extend Liquid schemes with low average maturity and lesser modified duration.
To reiterate, short-term investment planning are essentially meant to be a low-risk strategy and should works well primarily in volatile markets. Such arbitrage funds cannot be expected to deliver very high returns. In fact, such funds have typically generated debt fund-like returns in the past few years. Investors with a long-term view would be better off investing in regular equity funds.
May be only plus point is, Capital Gains are tax free after 1 years, but is it again justifying the call taken towards high risk – returns? i.e. not even more than average returns of 9.10% per annum! So the choice is with investor having clear objective.