Arbitrage Funds
Posted on 12-Aug-2016 Comments 15
There are a variety of products in the mutual fund spectrum. There are pure equity products, pure debt products and hybrid products. Then there are also products like ETFs which basically derive their value from an underlying asset like gold or global equities. In the middle of this spectrum, there are certain products which may have equity as their asset class but have the characteristics of a debt product. One such product is an Arbitrage Fund. It is basically an equity fund but the combination of equities and futures gives it the unique characteristics of a debt product. So, what exactly are these arbitrage funds all about?
What are arbitrage funds all about?
Arbitrage is the process of identifying and locking in a price differential.Let us assume that Reliance share is quoting at Rs.900, while the Reliance Futures expiring in 1 month is available at Rs.910. This is an arbitrage opportunity. If you buy the Reliance equity share at Rs.900 and sell the Reliance Future at Rs.910, then you can lock in a profit of Rs.10 for the month. This is risk-free profit as on the last Thursday of the month when the Futures contract expires, the cash price and the futures price will be the same. Now Rs.10 on Rs.900 works out to 1.11% for one month and nearly Rs.13.2% annualized. You may believe that 13.2% returns is an attractive return on an arbitrage fund. But in reality, an arbitrage fund will face a variety of challenges through the year and hence the actual returns will never be so high. Let us understand what are the challenges that an arbitrage fund will face?
Why returns on arbitrage funds is not that simple…
In reality, you will never get 1.11% return on Reliance each month.There are months when the return could be as low as 0.5% for the full month. Then there is the liquidity issue. Small movement in price ticks will ensure that your actual return may be lower than anticipated. The arbitrage spread between equity and futures is a function of interest rates and the state of the equity markets. For example, if the interest rates in the market go down then the arbitrage spread will also go down as it is ultimately like a debt product. Secondly, if equity markets are lack lustre then the arbitrage spreads may not be too attractive. When all these factors are taken into account, an arbitrage fund typically looks to earn between 8-9% on an annualized basis. Then what is so special about these arbitrage funds?
It is all about tax advantage on arbitrage funds...
The interesting part is that as per the CBDT any fund that holds more than 50% in equities is classified as an equity fund. The arbitrage fund buys equities and sells futures. Obviously, more than 50% of its asset allocation is to equities and therefore it is classified as an equity fund. That means the definition of long term in case of arbitrage funds is 1 year and long term capital gains are entirely tax free. It is this tax advantage that makes these arbitrage funds very attractive in post-tax terms. Let us understand this with an example.
How the tax advantage works for arbitrage funds…
Assume that you earn 10% return on your debt fund and 8% return on your arbitrage fund. After completion of 1 year you redeem your holdings in the debt funds and in the arbitrage fund. What is the post tax treatment? The arbitrage fund is an equity fund therefore any holding beyond 1 year is long-term capital gains. Since long term capital gains on equity are exempt from tax, your effective post tax returns will also be 8% on the arbitrage fund. The debt fund treatment will be a little more complicated. Since the definition of long term in case of debt funds is 3 years, the sale after 1 year will be classified as short term capital gains. Therefore, it will be tax date the peak rate of 30% (for simplicity we avoid surcharge). That means; your post-tax returns on the debt fund will 7% (10%-3% tax).Thus in post tax terms, the arbitrage fund is definitely more attractive than the debt fund.
In reality, arbitrage funds are more a substitute for short term liquid funds. Arbitrage funds are attractive largely due to the tax benefit associated with equity mutual funds. Typically the returns on liquid funds and arbitrage funds will be close to each other. The difference is that arbitrage funds have the tax advantage as they are classified as equity funds for tax purposes. One can derive the full benefit of the arbitrage fund only if they are in the top tax bracket. That is when the tax advantage will work in your favor. If you are in lower tax brackets, then there may not be a visible advantage in an arbitrage fund versus a debt oriented liquid fund.
Some of the top performing arbitrage funds…
Arbitrage & Arbitrage Plus - Returns (in %) - as on Aug 11, 2016
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