Fund Basics. The arbitrage advantage

If you’re looking for mutual funds as a short-term parking option, liquid funds, short-term debt funds and ultra short-term funds are the most obvious choices. But if you’re an investor in the higher tax brackets, these funds can prove quite tax-inefficient. Both their dividends and short-term gains are taxed at very high rates.

Arbitrage funds, which are treated as equity for tax purposes, offer a good alternative.

Arbitrage funds are equity mutual funds suitable for short-term investments, say, a year or so. These funds seek to generate returns mainly by exploiting arbitrage opportunities in the market. While many kinds of arbitrage are available, cash-futures arbitrage is generally used by arbitrage funds. As liquidity is important, most of their equity investments tend to be in large-cap liquid stocks, which find a place in the futures and options market.

Quite different from their other equity cousins that tend to hold on to their investments for a longer period, these funds use the price difference in the market between spot and futures to buy and sell simultaneously, thereby capturing the spread as gains. On expiry, the cash and futures price match, thereby leading to positive returns for the investor. As they have an increased rate of buying and selling, these funds tend to have high portfolio churn. They carry lower risk as their returns do not depend on market direction. As a result, they tend to be benchmarked to the liquid fund indices rather than to equities.

Most funds follow a similar investment mandate. Under normal circumstances for instance, Birla Sun Life Enhanced Arbitrage Fund, HDFC Arbitrage Fund and IDFC Arbitrage Fund invest between 65 to 90 per cent in equities and derivatives and the remaining 10 to 35 per cent in debt instruments.

Invesco India Arbitrage Fund, on the other hand, allocates between 65 and 80 per cent in equities and derivatives and the balance 20 to 35 per cent in debt and liquid instruments.

However, in exceptional circumstances, when arbitrage opportunities become unavailable, their asset allocation can shift to safer debt instruments, with 65-100 per cent holdings in them ; equities and derivatives will then make up the rest..

Some funds may even impose a cap on purchases. For instance, ICICI Prudential Equity-Arbitrage Fund imposes a cap of ₹10 crore per investor.

Effective July 2016, the fund changed its benchmark from CRISIL Liquid Index fund to Nifty 50 Arbitrage Index.

Arbitrage fund returns depend on prevailing interest rates in the market and the availability of arbitrage opportunities. For instance, over the last year, while the Sensex and Nifty 50 were flat, these funds managed to gain around 6.4 per cent, at par with the liquid fund indices.

During a three-year period, as the broader markets gained around 15 per cent, the returns from these funds were around 8 per cent.

However, over a five-year period, the gap reduces significantly. Average returns were around 8 per cent while the Sensex posted gains of 10 per cent.

As investments are based on price differentials, the expense ratio of arbitrage funds tend to be lower that that of diversified equity funds, thereby boosting overall returns. While the expense ratios of the actively managed funds are in the 2-2.5 per cent band, arbitrage funds report a much lower 0.5-1 per cent.

Arbitrage funds are popular with investors who prefer to exploit the taxation benefit. As these funds hold over 65 per cent of their investments in equity, capital gains tax is waived after one year. Those opting for the dividend mode are immune from dividend distribution tax as well.

As a result, these funds score over other short-term investments such as recurring deposits, fixed deposits, liquid and bond funds; these products are taxed as per the individual’s tax slabs.

Post-tax returns for these products tend to be lower than for arbitrage funds. These funds have to pay dividend distribution tax of close to 30 per cent too.

Arbitrage funds compare favourably with respect to liquidity as well. The time taken to convert your holdings in cash is between three and five days, only a tad higher than liquid funds and deposits.

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