Why arbitrage funds score over debt schemes in the medium term

Illustration: Binay Sinha
With debt funds remaining volatile for the past eight months now, arbitrage funds stand out. While medium- to long-term debt funds have seen periods of negative returns, arbitrage funds have been stable with consistent returns.

Sample this: In the past one year, the average returns from arbitrage funds have been 6.24 per cent. One year returns for the short-term debt funds category are at 4.83 per cent, credit opportunities funds are at 5.43 per cent, income funds are at 2.33 per cent, and dynamic bond funds category returns stand at 0.86 per cent.

Arbitrage funds are equity-oriented funds that take advantage of the price difference in stocks in the cash and futures market. They are best-suited for low-risk investors, as they offer steady returns and carry zero risk of capital losses. As the positions are fully hedged, these funds are effectively risk-free.

Investment advisors say that they work the best for an investor looking at medium-term investment – between one year and three years. In low-interest-rate environment, they are a better alternative to bank fixed deposits, especially for investors in the 30 per cent tax bracket. The fund category has been consistently delivering returns between 6-7 per cent year on year. What makes them attractive for investors in the highest tax bracket is the tax treatment.

If an individual redeems debt fund within three years of investments, the returns are clubbed with his income. As arbitrage funds invest in equities, they are taxed like an equity-oriented fund. If an individual redeems after one year, there could be short-term capital gains tax of 10 per cent. However, if capital gains from all equity investment are below Rs 100,000 in a financial year, there will be no tax. If an investor redeems before one year, he will need to pay short-term capital gains tax of 15 per cent.

The best performing fund category – liquid funds – have an average return of 6.81 per cent. If an individual withdraws money from these funds before three years of his investments, his post-tax returns are 4.77 per cent if he is in 30 per cent tax bracket and 5.45 per cent if he is in the 20 per cent tax bracket. Even if these investors had to pay long-term capital gains tax, the post-tax returns from arbitrage funds would work out to be 5.62 per cent, if you consider the category returns.

If an investor's your investment horizon is over three years, then he should look at income funds or credit opportunity funds, say investment advisors. For long-term investments, over three years, debt funds work out to be better as their taxes are lower considering the indexation benefit. They also have the potential to deliver higher returns.