Arbitrage funds - Smart way to improve your returns

Investing money for short-term, say up to 1-11/2 years has generally been an issue. As it is the interest rates / returns are quite low. On top of this, there could be taxation issues, which will further reduce the effective returns. 

Equity/equity funds may not be a prudent option for short-term. Therefore, we need to consider mainly the interest-based investment options.

What do we usually do?
Since it is quite convenient, very often the money keeps lying in the Savings A/c itself (also, maybe it is psychologically satisfying to see a big balance in one’s account). But don’t forget - this earns you just 3.5% p.a. interest and that too taxable. Hence, it is not good to keep too much money in the Savings A/c.

The next common thing to do is to make a FD. This may earn you 6-9% interest depending on the tenure. But this too is taxable (if you are in the highest tax bracket, even a 9% FD will fetch you just 6.3% post-tax returns). So, given the fact that there are better alternatives, this too may not be a very intelligent choice.

What are the Alternatives?
Certain debt MFs offer an attractive alternative to Bank FDs. In case you are sure about your investment horizon, you can opt to invest in Fixed Maturity Plans. Else, if you want quick liquidity, liquid plus/floating rate funds could be considered.

• Why FMPs are more lucrative than Bank FDs?

The pre-tax returns from these funds will be more or less in line with the returns from the Bank FDs. However, it is the difference in tax treatment on interest from bank FDs and returns from MFs, which enables MFs to give much better post-tax returns.

Interest from Bank FDs is fully taxable as per one’s slab rate. As against this, returns from Debt MFs will be taxed as either Dividend (@14.1625%) or Capital Gains (LT – @11.33% and ST – as per one’s slab rate).

Let’s assume that both FD and MFs give 8% returns. Then if you are in the 30% tax bracket, your post-tax return from Bank FD will be 5.60%. But, if you invest in MFs, you will earn either 7.01% (dividend if period is less than 1 year) or 7.09% (LTCG if period is more than 1 year).

Besides this, there is lot of convenience with MFs. MFs will deduct this Dividend Distribution Tax and pay you the net amount. You don't have to do anything. But in case of interest earning you will have to show it in your returns and pay tax, including advance tax. Also banks will deduct TDS on interest income. So at the year-end you will also have to get the TDS certificate from them.

How Arbitrage funds fit in?
Before we see how arbitrage funds can be useful, let’s first understand the concept of such funds.

Though, arbitrage funds invest in equity and derivatives such as futures & options, they are essentially debt funds. This is because when they invest in equity, they also take an exactly opposite position in futures. The objective is to capitalize on the difference in the prices in the cash market and the futures market (and hence the term arbitrage) rather than making money on equity or derivatives.

For example, say they buy Infosys shares @ Rs.1800/share in cash market on Aug 1. At the same time, they will sell Infosys shares in the futures market, which would be quoting for say about Rs.1815 (the difference in financial parlance is called the ‘cost of carry’).

Let’s say the price of Infosys on the expiry date of the futures contract (last Thursday of the month) is Rs.1900. Thus, the fund will make a profit of Rs.100 in the cash market [Rs.1900 – Rs.1800] and loss of Rs.85 [Rs.1815 – Rs.1900] in the futures market. (On the expiry date the cash and future prices are same). The net gain is Rs.15.

Or suppose the price of Infosys drops to Rs.1700. Thus, the fund will make a loss of Rs.100 in the cash market [Rs.1700 – Rs.1800] and profit of Rs.115 [Rs.1815 – Rs.1700] in the futures market. Again, the net gain is Rs.15

This way, the market movement does not affect them. They earn Rs.15, whatever may be the final price, which in this case works out to about 10% p.a. assured returns (@Rs.15 on Rs.1800 in one month).

In nutshell, arbitrage funds will yield returns more or less in line with liquid funds / floating rate funds or FMPs; and, more importantly, with practically very little risk.

For example, in last 6-12 months’ arbitrage funds have given about 9.25% p.a. average returns, while floating rate funds have given around 7.5% returns, liquid plus funds around 7.9% returns and FMPs around 8.5% returns.

Now, the key point – for tax purposes arbitrage funds are treated as equity funds. Hence, they enjoy lower tax vis-à-vis debt funds (see table below).

Thus they could give even better post-tax returns than debt MFs.

If the period is less than 1 year, both Debt Funds and Arbitrage Funds will give almost the same returns. At 8% pre-tax returns, the post-tax return works out to about 7%. But, if the period were 1 year, then post-tax yield would be 7.09% in debt funds and 7.73% in arbitrage funds.

Are Arbitrage funds OK to invest in?
There are no major risks associated with arbitrage funds unlike market-risk in equity funds or interest-rate risk in normal debt funds.

However, there could some minor risks. There may not be any arbitrage opportunities available, especially in bearish markets. In such cases, the arbitrage funds will work like liquid funds. Or on the expiry, the rates in cash and futures markets may not match exactly. This could marginally affect the returns. Or there could be some problems in executing the deals due to low liquidity.

Apart from this, one must keep certain points in mind:

• Arbitrage funds usually have an exit load for investment period less than 3 months. So make sure that you won’t need this money for at least 3 months.
• The returns are linked to expiry of contracts (which happens on the last Thursday of the month). So you need to be a bit careful about your redemption dates.

Concluding, therefore, one can say that arbitrage funds can be a good alternative to invest our short-term money, where we can earn high post-tax returns – with reasonable degree of safety and surety.

- Sanjay Matai

The author is an investment advisor and can be reached at sanjay.matai@moneycontrol.com.

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