Arbitrage funds have grown popular as a tax-efficient option, especially after debt mutual funds lost their tax advantages in the 2023 Budget. Assets under management (AUM) in this category jumped significantly from Rs 71,106 crore in April 2023 to Rs 1,98,981.2 crore in October 2024. With rising interest in equities and alternative investments, companies like Franklin Templeton India have recently introduced their own arbitrage funds, and many investors are giving them a second look.
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How Do Arbitrage Funds Work?
Arbitrage funds make money from price differences between the spot and futures markets. Fund managers buy stocks in the cash market and sell them in the futures market at the same time. The difference between these prices provides a locked-in return. According to Arun Kumar from FundsIndia, these funds typically hold 30-35% of their portfolios in short-term debt securities, such as AAA-rated bonds or government bonds with maturities of under one year.
The idea is that this “arbitrage” provides a predictable return since the profit is locked in from the start. As Deepesh Raghaw, a SEBI-registered advisor, explains, arbitrage is generally risk-free in terms of avoiding losses from a specific trade, making it an appealing choice for conservative investors.
Tax Efficiency of Arbitrage Funds
Arbitrage funds are more tax-efficient than debt mutual funds. Debt funds, post-2023, are taxed according to the investor’s income bracket, potentially up to 42.7% for high-income earners. In contrast, arbitrage funds are taxed as equity investments. If held for over a year, they incur a capital gains tax rate of only 12.5%, and gains below Rs 1 lakh are tax-free. This tax efficiency makes arbitrage funds especially attractive for high-net-worth individuals (HNIs).
Potential Drawbacks and Limited Opportunities
Despite these advantages, arbitrage funds come with certain risks. Their performance can vary based on market conditions. When price gaps between spot and futures markets narrow, or if futures trade at a discount, fund managers may need to hold cash or invest in lower-yield debt. Kaustubh Belapurkar from Morningstar points out that such scenarios could limit returns.
Short-term declines can also occur in flat or bearish markets, though generally, arbitrage funds yield positive returns over three to six months. Additionally, returns can fluctuate based on Foreign Institutional Investor (FII) activity. Reduced FII participation often increases spreads, which can benefit arbitrage funds, while higher FII activity might reduce spreads.
Who Should Consider Arbitrage Funds?
Arbitrage funds are a good choice for investors in higher tax brackets, especially those who are comfortable with occasional dips. Kumar recommends them for investors in the 30% tax bracket and sees them as viable for those in the 20% bracket. However, he suggests that investors in the 10% tax bracket may find better options in liquid funds. Arbitrage funds can complement liquid funds as part of an emergency portfolio for those who can tolerate minor fluctuations in returns.
Choosing the Right Arbitrage Fund
When selecting an arbitrage fund, it’s essential to look at the fund’s expense ratio and historical performance. Rolling returns over six months or a year can indicate how well a fund captures arbitrage opportunities. Larger funds may also be more appealing, as they offer broader diversification to manage risks. Reviewing the credit quality of the debt portion of the fund is also advisable to ensure stable returns.
Opinion and Conclusion
Arbitrage funds offer a solid tax-friendly alternative to debt mutual funds, particularly for HNIs and those seeking short-term returns with lower risk. However, they do carry some limitations due to the market’s reliance on spread opportunities. In uncertain or bearish markets, these funds may not deliver as consistent returns as liquid funds.
In conclusion, arbitrage funds can be a beneficial part of a diversified portfolio, especially in the current tax environment. However, they require a balanced view of risk and return. As always, it’s wise to assess your financial goals and tax situation when choosing the right investment vehicle.
