With equities volatile and bond yields elevated, income plus arbitrage funds offer an ideal option to park surplus money. The debt portion captures accrual and potential mark-to-market gains if yields soften, while arbitrage provides low-volatility returns.
Income plus arbitrage funds invest around 35–65% in arbitrage funds, with the balance in debt funds. The structure qualifies for 12.5% long-term capital-gains tax after 24 months, compared with tax at slab-rate for debt funds—making it especially relevant for investors in higher tax brackets.
The debt component allows investors to lock into relatively attractive accrual opportunities available at current yields. Any moderation in yields can potentially provide some mark-to-market benefit as well.
The arbitrage component seeks to capture the spread between cash and futures markets without taking significant directional equity exposure. The arbitrage side benefits when volatility in equity market picks up—those cash-futures spreads usually widen in choppy markets.
This makes the category relevant as an alternative to traditional short-term debt allocations such as liquid, money market funds, particularly for investors who can stay invested for more than two years. “I see this as a good parking spot if you have a 24-month runway. If you need the money in a few months, liquid or overnight funds are still the safer bet,” says Sonam Srivastava, founder, Wright Research PMS.
Higher post tax returns
Income plus arbitrage funds have delivered average returns of 5.7% over one year, 6.2% over two years and 8.5% over three years, compared with 6.4%, 6.7% and 6.9%, respectively, for liquid funds. If held for more than two years, gains from income plus arbitrage structures are taxed at 12.5% as long-term capital gains, whereas returns from liquid funds are taxed at the investor’s applicable slab rate.
For investors in higher tax brackets, this can materially improve the post-tax return differential over longer holding periods. “For investors with a horizon of over two years, the combination of return potential and tax efficiency can make them an attractive alternative to traditional short-duration debt allocations,” says Nirav R Karkera, head of research, W by Groww, wealth management arm of Groww.
What to consider
Investors should examine the fund’s debt-portfolio quality, duration risk, allocation range, exit load and the expense ratios of both the fund-of-fund and underlying schemes. “These are not substitutes for emergency money or overnight liquidity, and short-term negative returns remain possible,” says Aditya Agarwal, chief investment officer, Avisa Wealth Creators.
Fund-manager decisions can play an important role because the two underlying return engines behave differently across market conditions. Investors should not assume that tactical allocation will always add value. Incorrect duration calls, compressed arbitrage spreads or poor timing of allocation shifts can reduce returns. So, apart from past performance, the consistency of the investment process and the manager’s track record across different market cycles become important.