Arbitrage Funds 2016

 

The returns may not sustain at earlier levels, but superior tax benefits still make these funds ideal for parking short-term money

 

While most investors would rather never encounter stock market volatility, in vestors betting on arbi trage funds have actually benefited from it. For over a year now, investors have been lapping up these funds, which gain from opportunities presented by fluctuating markets. Superior tax benefits is another attraction after debt funds and fixed deposits lost their mojo under revised tax rules. Not surprisingly, the aggregate corpus managed by these funds at the end of November doubled to `32,140 crore from a year ago. But will these funds remain a good investment avenue going ahead?

Favourable tax treatment

Arbitrage funds generate returns by capitalising on the price differential of securities between two markets, mostly the spot and derivatives market. Simply put, these funds simultaneously buy shares in the cash segment and sell futures of the same company that are trading at a reasonable premium. On the day of expiry of the futures contract, the cash and futures prices coincide, thus generating positive returns for investors.The returns from an arbitrage fund are thus dependent on the spreads available be tween the cash and futures position, which are more prominent in volatile markets.

Arbitrage funds are hybrid in nature, investing in both debt and equity.They strive to maintain the equity fund status by investing at least 65% of the corpus in stocks. However, by selling the same stocks in the futures market, they book arbitrage profit and reduce risk. This makes them attractive for short-term investors. Gains realised after more than a year attract no tax on capital gains. Also, dividends are tax-free in the hands of investors and there is no dividend distribution tax on the fund. Whereas gains realised from a debt fund are taxed at marginal rates if held for less than 3 years and thereafter at 20% after adjusting for inflation. The favourable equity tax treatment and debt-like risk profile makes arbitrage funds the ideal investment choice for those in higher income tax brackets .

Narrowing spreads

While experts insist these funds remain the best bet for investors looking at a short-term investing horizon, they are quick to add that re turns are not likely to sus tain at earlier levels. Till a few months back, these funds were comfortably yielding returns in ex cess of 8%, but have now come off slightly.

Over the past three months, liquid funds have fared much better, delivering 1.81% com pared to 1.54% clocked by arbitrage funds. Growing size of arbitrage funds will present challenges in the coming months. Last year's performance is unlikely to repeat this year, given that the size of the funds has grown significantly." When there is too much money chasing limited arbitrage opportunities, the returns are bound to diminish.  While continued volatility will provide arbitrage opportunities going forward, the spreads are likely to narrow down so returns from these funds may not be as high as before

Both, however, agree that arbitrage funds would remain the preferred bet for those looking to park money for the short-term.The post-tax returns from these funds will continue to trump that offered by short term debt funds and fixed deposits. After a year, investors stand to pocket a post-tax return of nearly 8% from arbitrage funds while an individual in the 30% tax bracket would only fetch around 5.6% post-tax in a short-term debt fund or FD. It makes sense to invest in arbitrage funds if the purpose is to get better tax treatment on short-term money, yielding return above that offered by comparable debt instruments.

Some experts feel tax benefits offered by these funds may not be available for long. Given that the government has previously plugged any such tax arbitrage opportunities, it may consider removing the tax advantage of these funds and bring them on par with other products. And, even though these get taxed as equity funds, one should not expect equity-like returns.

 

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