Arbitrage Mutual Funds: Another Smart way of earning high tax free returns in short duration

If I ask any one of us generally about safe and tax efficient short-term investment avenue to park surplus money other than the fixed deposit, most of us will answer “Liquid Funds are the best for a short-term investment”.  Many of us believe that Liquid Funds are the best alternative to Fixed Deposit which might be true also for some case. But is it really true always? Are Liquid Funds the best tax efficient option to park short term funds (three months and more).If your answer is ‘Yes’ then you must read below to understand why Liquid funds are not tax efficient short-term investment avenue.

The convenience and better absolute returns from the Liquid Fund for very short-term, even for overnight investing is very significant. This makes it attractive even though there is no tax advantage as for all debt based mutual funds (liquid fund is a debt based mutual fund) we have to pay short term capital gain tax based on the slab rate if it is redeemed before three years. So if a person is at highest tax slab, he has to pay almost 1/3^rd of the income as capital gain tax, in a way tax liability is similar to the FDs.

So what could be another option to get better returns without risking the capital?

Answer could be the Arbitrage Funds. Arbitrage Fund leverages the price differential in the cash and derivatives market to generate returns. The returns are directly dependent on the volatility of the asset class i.e. Equity Market. However, It would still be market neutral i.e. No specific equity risk as they would be buying and selling the stocks simultaneously in cash & future market.

These funds are hybrid in nature as they have the provision of investing a small part of the portfolio in debt markets.

Arbitrage Mutual Funds are mainly for low risk-taking investors. In a situation of high and persistent fluctuation, Arbitrage Funds offer investors a safe opportunity to park their hard-earned money. These funds take advantage of the Equity market inefficiencies and secure profits for the. These funds invest primarily in equities; hence their tax treatment is same as equity mutual funds.

What is Arbitrage and how they earn?

As the name suggests, Arbitrage means encashing the inefficiencies of two markets. In equity market these are the price differences between cash segment stock price and future segment (F&O). These funds encash the opportunity (which we call as arbitrage opportunity) of the price difference in these market. The difference in these market exists due to insufficient flow of information between two market prices and time value of money however it is temporary in nature. Sometimes due to huge buying/selling in the particular segment of stock or huge volatility in market generates arbitrage opportunity.

There are various reasons due to which these price differential exists like stock specific news i.e. quarterly or annual results, corporate governance issue, bulk buying or panic selling etc. these events generates arbitrage opportunity because of the relative price difference in cash and future market. Generally Arbitrage Fund uses hedging strategy; they buy stock from cash market and sell those stocks in the future market to lock price difference between two segments of the market.

Arbitrage strategies followed are different for different asset management companies; some may adopt strategies like Index/Stock cash – Index/Stock future, ADR/GDR, Buy-Back Arbitrage, Hedging and Alpha strategies, cash-future arbitrage strategies or corporate action or event driven strategies. When fund manager feels market having very less volatility or arbitrage opportunity, he may invest a sizeable amount in debt or money market securities to generate stable returns.

So how it works?

Assume that price of XYZ stock is quoting at Rs. 100 in the cash segment, whereas the price in the Future market is Rs. 101. At this point of time fund manager, can make the profit by purchasing stock in cash segment and selling an equal number of shares in the future market. So after doing this translation fund manager locks in Rs 1 profit per share on the day of settlement without getting worried about daily price movement or market directions.

Investment done is the cost paid for cash market buy and margin value of the future contract. Profit will be booked on the day when stock price of both the market match or on the last day of settlement and the fund manager will reverse his position in stock, he will sell stock holding in cash segment which was purchased and will buy contract in the future segment.

Mostly returns generated by schemes are based on the efficiency of fund manager’s opportunity spotting skill and trade execution skill of his team. Cash price and Future contract price generally converges at the end of the month, so he will make very low risk return of around 12% [(101-100)*12/100].

Who could be the investors?

Arbitrage mutual funds are alternate to liquid/short term funds and mostly suitable for parking money for the period of 1 month and above. These funds are basically locking available spread, so return are purely dependent on arbitrage opportunity available at particular point of time. Arbitrage Funds have exit loads generally in the range of 7 days to 3 months, it should be kept in mind before investing. Another important aspect is Arbitrage Funds are mildly fluctuating in the short run, sometimes even 1-month scheme return do not look attractive compared to Liquid Fund, ultra or short-term income fund. Monthly returns of Arbitrage Funds are always volatile due to monthly expiry at different spreads.

These funds are for parking short term cash and are not long-term wealth creators. Arbitrage Fund do not invest like other equity-oriented schemes, they do not take any directional bet on Equity market, they just lock the spread available between two prices at same point of time, hence Arbitrage Funds are not for the long-term wealth creation. So an investor should use it as a liquid investment and do not make it a major part of the portfolio.

Arbitrage Funds are mostly suitable for those investors who are in 20% or 30% tax bracket. If an investors investment horizon is less than 1 year, go with the Dividend option and investor who wish to stay invested for more than 1 year and less than 3 years should go with Growth option. An investor who is willing to invest for more than 3 years can also look for growth plan of the Liquid Fund, FMP, Ultra short-term or short-term mutual fund also.

How it benefits the investors?

For those investors who are in 10% tax category, Liquid Fund returns are in their favour compare to Arbitrage Fund returns and that is because of tax treatment on a capital gain (Short Term Capital Gain tax is as per slab rate). But for investors, who are already paying 20% or 30% income tax, due to the adverse tax treatment of debt mutual fund, their actual post tax earning will be very less if invested in Liquid Funds. Hence any return you earn after holding it for 12 months is tax free, and in case you hold it for less than 12 months and make any profits, the taxation is 15% (short term capital gains tax) however the dividend received anytime is tax free.

Investment Horizon	Debt Mutual Funds		Arbitrage Mutual Funds
	Dividend Distribution Tax	Capital Gain Tax	Dividend Distribution Tax	Capital Gain Tax
Upto 1 Year	Individual 28.84% Company 34.61%	Income Tax Slab	NIL	15%
Between 1 and 3 Years	Individual 28.84% Company 34.61%	Income Tax Slab	NIL	NIL
After 3 Years	Individual 28.84% Company 34.61%	20% less indexation	NIL	NIL

For example an investor who is paying 30% income tax (ignoring surcharges for the sake of simplicity) invests in Liquid Fund for the period of 6-month to park surplus money. After six months of investment, his post-tax return would be much lower compared to return generated by Arbitrage Fund (here we have assumed 8% annualised return in liquid funds and 7.5% in Arbitrage funds based on current returns). He will be earning merely 2.8% post-tax return from the Liquid Fund scheme against 3.8% post-tax return from Arbitrage Fund. If he has invested Rs. 10 lakhs for six months, just by keeping the funds in arbitrage funds instead of liquid funds he would be earning Rs. 9500/- extra which is 34% more as compared to liquid funds.

Particulars	Liquid Fund	Arbitrage Fund
Annualised Return	8.0%	7.5%
Tax Slab	30.0%	30.0%
6 Months Return	4.0%	3.8%
Tax on Returns	1.2%	-
Net Return	2.8%	3.8%
Amount invested for 6 Months (Rs.)	10,00,000.00	10,00,000.00
Net Income (Rs.)	28,000.00	37,500.00
Difference in Income (Rs.)		9,500.00
% Difference		33.9%
Tax Slab is taken the highest bracket and ignore the surcharge for the sake of simplicity

It is clear that by selecting the correct investment vehicle considering time frame and individual’s tax bracket, one can actually get much higher returns by doing his homework properly and understanding the tax treatment of different class of mutual fund schemes.