Use of Arbitrage Mutual Funds in Asset Allocation

When planning our asset allocations, we usually think about equity and fixed income for our different investment needs. Equity investments are made over long investment tenures (usually 5 years or longer) and primarily for the purpose of capital appreciation. Fixed income investments are made for short to medium tenors (1 to 3 years), primarily to meet our income needs. Apart from these two investment needs, we also should plan for our very short term (less than 1 year) needs e.g. creating an emergency fund to meet sudden expenses, parking one-time cash-flows or surplus funds for a short duration to meet an upcoming expense or investment. For very short term investments, we should ensure that the investment has very low risk (high degree of capital safety) and high liquidity (we can redeem the investment at any time, without incurring any cost).

Liquid funds, ultra-short duration debt funds, money market funds, low duration funds etc. are suitable for very short term investment needs. These funds invest in money market or debt securities with very short residual maturities and have very low interest rate risk (compared to longer duration debt funds). They are also highly liquid – liquid funds for example, have no exit loads and redemption requests are processed within one business day (subject to cut-off times). These funds are very popular with corporate and institutional investors for parking their surplus funds.

Retail investors usually keep their surplus funds lying in their savings bank account, but liquid and other very short duration funds can give much better returns than savings bank interest.

Another category of funds known as arbitrage mutual funds can be excellent substitutes for liquid funds. Unlike liquid and other debt funds, arbitrage funds enjoy equity taxation enabling them highly tax efficient returns.

In this blog post, we will discuss about arbitrage funds.

What are arbitrage funds?

Arbitrage fund is a type of mutual fund that leverages arbitrage opportunities in capital markets. In investment parlance, arbitrage is the opportunity to make risk free profits by exploiting pricing inefficiencies in different segments of the market e.g. between cash and derivatives segments, between stock exchanges etc. Arbitrage funds are very low risk mutual fund schemes. Historically, arbitrage fund returns have been similar to liquid fund returns. However, arbitrage funds usually charge a small exit load for redemptions within 30 days. You should have investment tenure of at least 30 days to up to a year for arbitrage funds.

How does arbitrage works?

A common arbitrage opportunity arises from the pricing mismatch in cash and F&O market. Suppose the share price of a company is Rs 100 and the futures price is Rs 110. On the expiry of the futures contract, the spot price (share price in cash market) and futures price will converge. If you buy 1,000 shares of the company in the cash market and sell 1,000 futures, you will lock in a gross profit of Rs 10,000 today itself irrespective of whether the price rises or falls.

Suppose the share price on expiry is Rs 120 (spot and futures). In the cash market you will make a profit of Rs 20 (Rs 120 – 100) X 1,000 shares = Rs 20,000. At the same time, in the F&O market you will make a loss of Rs 10 (Rs 100 – 110) X 1000 shares = Rs 10,000. The net profit for you will be Rs 10,000.

Suppose the share price on expiry is Rs 90 (spot and futures). In the cash market you will make a loss of Rs 10 (Rs 90 -100) X 1,000 shares = Rs 10,000. In the futures market you will make a profit of Rs 20 (Rs 110 – 90) X 1,000 = Rs 20,000. You can see that whether the share price moves up or down, you will make a profit.

The example above explains why arbitrage funds are very low risk investments. For the sake of simplicity, we have ignored the effects of transaction costs e.g. brokerage, securities transaction costs etc. in arbitrage profits. The fund manager of arbitrage schemes takes into account all the factors in identifying arbitrage opportunities for his / her scheme.

Features of arbitrage funds investors need to consider

• Arbitrage mutual Funds enable investors to earn short term returns by taking minimal risks


• Arbitrage Funds offer investors high liquidity and better returns than savings bank account


• Arbitrage funds tend to give good returns in volatile market conditions, but historical data shows that arbitrage funds give higher returns in rising markets


• Arbitrage fund investors should be prepared for very short term volatility before expiry of futures contract


• Sometimes the fund manager may find better divergence between spot and futures price in later monthly series relative to current month series of F&O contracts; which implies that the investor should be prepared to hold on to their investments for 2 or 3 months, if required


• Arbitrage funds offer considerable tax advantage for investors in the higher tax brackets. We will discuss this in more details in the next section.

Arbitrage Funds Tax Advantage

Arbitrage funds enjoy equity fund’s taxation. Short term (investing holding period of less than 1 year) capital gains are taxed at 15%. Long term (more than 1 year) capital gains of up to Rs 1 Lakh are tax free. Long term capital gains in excess of Rs 1 Lakh are taxed at 10%. Capital gains from debt mutual funds including liquid funds for investment holding period of less than 3 years, on the other hand are taxed as per the income tax rate of the investor.

Dividends paid by arbitrage funds are tax free in the hands of the investors; however the fund house has to pay dividend distribution tax (DDT) of 10% before paying dividends to investors. Debt funds including liquid funds have to pay dividend distribution tax of 28.8% before paying dividends to investors. Clearly for investors in the higher tax brackets, arbitrage funds enjoy a big tax advantage over debt funds. Also, for investors who need cash-flows in form of dividends, arbitrage funds provide more tax efficient returns.

In the last 1 year average liquid funds return was 6.46% returns; if you invested Rs 10 Lakhs in liquid funds, assuming you got 6.46% returns, your capital gains would have been Rs 64,600. If you were in the 30% tax bracket, your tax obligation would have been Rs 19,380 and your post tax profit would have been Rs 45,220. Over the same period arbitrage funds gave average 5.6% return; on Rs 10 Lakh investment, your profit would have been Rs 56,000. Since it is within the Rs 1 Lakh long term capital gains tax exemption limit, your profit would be tax free. Your post tax return in arbitrage funds in this example was much higher than liquid funds.

Conclusion

In this blog post, we discussed how arbitrage funds are useful for very short term investment options in your asset allocation. Arbitrage mutual funds offer a high degree of safety, high liquidity, stable and extremely tax efficient returns. As discussed in this post, investors need to have investment tenure of at least a few months for arbitrage funds; investment tenure of over 12 months is ideal from a tax perspective. Investors should discuss with their financial advisors if arbitrage funds are suitable for parking their surplus cash.