Arbitrage funds may be good substitutes for short-term debt funds

Since June, three asset management companies have launched arbitrage funds, taking the number of such funds in the Indian market to 14. These funds have got a lot of attention as a substitute for short-term debt funds after the Union Budget reduced the tax benefits for investors in debt funds.

Arbitrage funds make money by gaining from the difference in price of a security in different markets. These funds are hybrid as they invest a sizeable money in debt markets.

"Arbitrage funds have been present in the market for a long time. But their returns have been comparable with those given by short-term debt funds, which is why they have not got much investor interest. But the changes in tax rules have made debt funds unattractive for the short term," says Neeti Trivedi, partner, Acumoney Consulting.

In the one year ended August 8, the best performing fund in the category was Kotak Equity Arbitrage Fund, with returns of 10.03%. The worst performing was Birla Sun Life Enhanced Arbitrage Fund, which returned 8.10%.

SHOULD YOU INVEST?

Vidya Bala, head, Mutual Fund Research, fundsindia.com, says arbitrage funds are useful. "They are basically used to hedge or limit risk. Hence, one can invest in them any time." However, she agrees that these funds work best in volatile markets when the fund manager gets a lot of opportunities for arbitrage between cash and derivatives segments.

Lakshmi Iyer, chief investment officer (debt) and head of products, Kotak Mutual Fund, believes there are reasonably good arbitrage opportunities in the current equity cash and futures markets. "Given that the bullish undertone is likely to continue, we believe it is the right time to look at equity arbitrage funds."

Seemant Shukla, associate director, Edelweiss Asset Management, agrees. "Since 2007, there have been only three-four months in 2008 when there have not been good arbitrage opportunities."

These funds offer investors a tax advantage too. "Due to their equity orientation, dividends are tax-free and so are capital gains if the units are held for more than one year, making them more tax efficient than liquid and debt funds," says Shukla. Hence, arbitrage funds should be a part of all asset allocation strategies, he says.

At present, short-term gains from debt funds are added to the income and taxed according to the person's tax slab. Long-term gains, if the units are held for more than three years, are taxed at 20% with indexation. Indexation involves adjusting the purchase price with inflation. It lowers gains and, hence, the tax burden.

"Arbitrage funds, although categorised as equity funds, can replace a part of your liquid fund portfolio. These do not qualify as a long-term investment for generating wealth but are more an instrument for parking short-term money. Not more than 5-10% funds should be allocated to this category of funds," says Trivedi of Acumoney Consulting. Most arbitrage funds charge a fee if you sell before three months.

Adding a word of caution, he says, "With a slew of new fund offers and additional investments, it remains to be seen if these funds can keep up their performance in view of limited arbitrage opportunities available in the market."

That is why some experts advise caution. "It's not a good time to invest in arbitrage funds. These are good investment in a sideways market but not now when we are looking at a possible bull run in equities. If we look at the debt market, too, we will most probably see a downward interest rate cycle. So, it is a good time to invest in debt funds also. Hence, we are not recommending arbitrage funds over equity and debt funds in the current market environment to our long-term investors," says Rohit Shah, founder, GettingYouRich, a financial planning firm.

EQUITY ALLOCATION

Many arbitrage funds say they invest in debt instruments when they are not able to find opportunities in equity markets. This makes investors fear that if the debt portion crosses the 35% mark, the fund may be treated as a debt fund and taxed accordingly. Bala of fundsindia.com says this flexibility is good. "It is good for the fund house to give itself leeway to invest in debt if arbitrage opportunities are hard to come by. This is better than the risk of unhedged equity allocation."

Trivedi says funds need to stick to the mandate to avail of the tax benefits of equity funds. The reason it is difficult for investors to gauge the level of debt investment in an arbitrage fund's portfolio is derivatives transactions. "The funds typically ensure that they invest at least 65% in equities. Since this includes derivatives transactions as well, the funds are able to maintain the stated allocation," says Trivedi.

VOLATILE OR UNIDIRECTIONAL?

Do arbitrage funds do well only in volatile markets? The answer seems yes, because in volatile markets, there is a wide gap in prices in cash and derivatives segments, providing opportunities for making money.

Shukla of Edelweiss says, "If you analyse data since 2007 and split it in periods when either the Nifty has moved significantly upwards or significantly downwards, you will observe that the base case returns delivered by arbitrage funds have been 7-8%. The highest returns have been 10-11%, proving that these funds can deliver stable and consistent returns across market cycles."

Kotak's Iyer says arbitrage funds do well in bull markets too. "These funds do well in a market where sentiments are a tad bullish as futures trade at a premium during such times."

Explaining, Shukla says stocks trade at different levels in cash and futures markets. The reason is the risk involved in the futures market.

"Thus, irrespective of the market movement, there will be a difference in cash and futures markets. This will ensure arbitrage opportunities exist even if the markets are unidirectional or range-bound," he says.