Arbitrage funds are gaining favour as investors flock to safety: Experts

Topics Arbitrage funds | IL&FS

Arbitrage funds are gaining favour as the perceived safety tag associated with these schemes is helping them pull in money from debt investors.

Assets of these hybrid funds have grown 36 per cent in the past five months to Rs 68,541 crore as on August 31, 2019. Most of the funds in this category have returned between 6.5-7 per cent in the past year, and may offer better returns than some debt categories. As a category, one-year returns of these funds are higher than that of medium duration, short duration, and credit risk funds, and on a par with liquid and ultra-short-term funds.  

Arbitrage funds work by exploiting the price differential between the cash and the futures markets. Instead of buying stocks and then selling them later, arbitrage funds buy shares in the cash market and simultaneously sell them in the futures market.

“Arbitrage funds have gained favour among debt investors who want to avoid credit and duration risks and diversify their portfolio. There are no major risks associated with arbitrage funds since equity positions are hedged, and there is no directional call on the market,” said Joydeep Sen, a financial planner.

Investors in liquid funds, in particular, could be looking at arbitrage funds, as the former are expected to give lower returns in the coming months owing to regulatory changes. Liquid funds will be required to hold 20 per cent in cash and cash equivalents, marked to market, and an exit load will be charged.

“The advantage of arbitrage funds is that, while the gross returns for these funds may be equal to or less than liquid funds, one can expect higher returns post tax, since these funds enjoy equity taxation,” said Amol Joshi, a distributor.

These funds are considered as equity for tax purposes. Long-term capital gains for arbitrage funds are taxed at 10 per cent, while short-term capital gains will be levied a tax of 15 per cent. For liquid and other funds, short-term gains are added to investors’ income and taxed as per their tax slab, whereas long-term gains are taxed at 20 per cent after applying the indexation benefit.

Dividends from arbitrage funds are subject to dividend distribution tax of 10 per cent, while that for liquid funds is taxed at 29.1 per cent. This will come into play for those opting for the dividend option in these funds.

Experts believe that investors must have a 2-3 months horizon while investing in arbitrage funds for superior returns. “This is a bit longer than liquid funds where you can invest even for few days or weeks,” said Joshi.

In most cases, arbitrage funds invest the 35 per cent of their assets in debt/money market component in good quality securities. But there could be exceptions. For instance, an arbitrage fund has in the recent past given negative return because of default in IL&FS.

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