Assets under management in the arbitrage funds category have risen to Rs 81,386 crore as April 2021, compared to Rs 58,704 crore a year ago. Investors have been drawn to these funds on the back of falling short-term interest rates over the past one year.
On paper, arbitrage funds seem like ideal avenues for parking your short-term surplus. These are funds come with an equity tax advantage as well. Besides, liquid and overnight mutual funds have consistently given low returns over the past one year. For those who wished to park their surplus cash for a few months, or start a systematic transfer plan into an equity fund, liquid funds have disappointed. But that’s no reason to dump liquid schemes just yet.
Tax-friendly, but volatile
Arbitrage funds were started in around 2005 as alternatives to liquid funds for investors wanting to park their short-term cash. Kotak Equity Arbitrage Fund is the oldest and the largest arbitrage fund in the MF industry, with assets of Rs 18,952 crore. Since arbitrage is between the cash and futures markets in equities, it comes with equity taxation.
But arbitrage funds are in a peculiar situation. The cash-future arbitrage is carried out on stock exchanges, which nullifies counterparty risk. But there is a credit risk that these funds carry when the money is deployed in short duration fixed income instruments. Also, when the stock markets turn volatile, there may not be enough opportunities to deploy money in cash-future arbitrage. This may eat into returns.
At the moment, stock markets are around their all-time highs and valuations are expensive. If volatility suppresses the spreads, like it did last year, then returns from arbitrage funds may not be attractive. For example, in June and July 2020, arbitrage funds as a category witnessed NAV erosion of 0.2 percent and 0.11 percent, respectively, as per Value Research data.
Why liquid schemes score over arbitrage funds
Overnight schemes offer investors bond portfolios that mature overnight. These carry minimal interest rate risk (securities parked in overnight securities) and almost zero credit risk.
Liquid funds do carry both interest rate and credit risks. In the past, some liquid funds have been taking some interest rate risk, but things have improved post the Franklin Templeton episode.
A one-year time frame necessary
Despite being income-tax friendly, arbitrage funds can be volatile, and investors can lose money. Joydeep Sen, Corporate Trainer-Debt, says, “Investors should ideally invest in them with a one-year time frame. Do not consider arbitrage funds if you cannot hold on to them for at least six months.”
When you hold on to your investments for one year in an arbitrage fund, the gains are taxed at the rate of 10 percent, if the gains are in excess of Rs 1 lakh. In the long term, the volatility is taken care of. For example, over the last one year, liquid funds on an average gave 3.15 percent returns, while arbitrage funds managed 2.66 percent. This translates into a post-tax yield of 2.20 percent in the case of liquid funds for an investor in the 30 percent tax bracket. But for arbitrage funds, the post-tax yield works out 2.39 percent, assuming 10 percent tax.
If you wish to invest just for a few months, “consider overnight, liquid and ultra short duration schemes, instead of arbitrage funds,” says Vinayak Savanur, Founder and CIO at Sukhanidhi Investment Advisors.