Why Arbitrage Funds Are Attracting Investors After Budget

Since Finance Minister Arun Jaitley unveiled the Budget on July 10, arbitrage mutual funds have suddenly become the flavor of the season. The reason: Mr Jaitley changed the tax provision for debt mutual funds.

Arbitrage funds are categorized as equity funds but its near risk-free nature, along with its tax advantage against debt funds, has seen investors getting attracted to this fund after Budget. On returns side, arbitrage funds are comparable to that of debt funds.

An arbitrage fund is a type of equity mutual fund that tries to take advantage of the price differential (of the same asset) between two or more markets or market segments. Arbitrage funds have the potential to deliver better post-tax returns at a similar level of risk compared to debt funds (money market/liquid funds).

Assets of equity mutual funds rose to a record high of Rs 2.52 lakh crore in July, aided by monthly inflows Rs 10,845 crore, highest since January 2008, according to Crisil. A 22.5 per cent gain in Nifty since the start of 2014 has buoyed sentiment in equity funds. However, a large of the inflows into equity funds was due to arbitrage funds, say fund managers. According to estimates, in July, arbitrage funds accounted for nearly half of the inflows into equity funds.

"Some of the money has come into arbitrage funds. They offer the benefit of equity funds in terms of taxation and returns are somewhere near 8 per cent or so in line with some of the debt funds," said Mahesh Patil, co-chief investment officer at Birla Sun Life Mutual Fund. (Watch)

Regardless of tax advantage in case of arbitrage funds, Mr Patil is optimistic that more money will flow into equity funds with early signs of economic recovery and other asset classes not performing well.

How Arbitrage Funds Work

Arbitrage funds exploit the difference in the price of a stock between cash and derivatives markets or even different stock exchanges such as BSE and NSE.

For example, the price of a stock quotes at Rs 100 in cash market and Rs 102 in futures market. The fund manager would buy in cash market and simultaneously sell in futures market to lock in a profit of Rs 2 per share.

Arbitrage funds work well in volatile markets as fund managers are able to capitalize on differences in prices of a stock between the equity market and the futures market. Arbitrage fund managers reduce the risk in equities by hedging them using derivatives.

Arbitrage funds also deploy surplus cash in debt securities and money market instruments.

Returns

According to Value Research Online, arbitrage funds on an average offered a one-year return of 9.44 per cent (as of August 11, 2014) as compared to 9.28 per cent in liquid funds and 9.80 per cent in fixed maturity plans. Liquid funds and fixed maturity plans are types of debt funds. However, with inflows increasing into arbitrage funds, the opportunities to cash in on differential between markets could decline in future. "The returns have been better due to the bullish markets but with so many funds coming in it could come under pressure," Mr Patil added.

Taxation

Arbitrage funds are categorised as equity funds from a taxation perspective. This gives arbitrage funds the benefit of zero taxes on long-term gains (holding period of more than a year). If the holding period is less than a year, capital gains (short-term) are taxed at 15 per cent.

In contrast, the government increased the long-term capital gains tax on debt-oriented mutual funds from 10 per cent to 20 per cent and changed the definition of 'long term' for debt mutual funds to 36 months from 12 months effective from July 10.

Short-term capital gains on debt funds are added to one's income and taxed as per the individual's income tax slab.

(Disclaimer: "Investors are advised to make their own assessment before acting on the information.")