Arbitrage funds have gained traction among investors of late, with close to Rs 23,800 crore in net inflows recorded in FY24 till July 31. In July alone, these schemes saw Rs 10,074 crore in net inflows.
According to industry experts, the removal of the indexation benefit from debt funds back in March came as a blow to fixed income, and arbitrage funds have benefited since. This is because gains from arbitrage funds are taxed at par with equity funds. While they attract a 15% tax rate for less than a year, holding on to them for more than a year would mean a long-term capital gains tax of 10%.
“In March, we saw the removal of the indexation benefit in debt funds, which explains the shift in bets to arbitrage funds. A more attractive taxation regime has made the category popular,” said Sahil Kapoor, head of products at DSP MF.
Further, spreads of arbitrage funds also tend to move in line with short-term rate fluctuations, making it an attractive proposition, he added.
Arbitrage funds invest a minimum of 65% in equity and equity-related instruments. These funds buy a stock in the cash market and simultaneously sell it in the futures market at a higher price. The return generated is the difference in prices in the two markets.
The total assets managed under the arbitrage category stood at Rs 78,749 crore at the end of FY23, when March saw an over Rs 12,000-crore dip. However, the category has steadily gained interest, with the total AUM at Rs 1.04 trillion as of July 31.
However, while this category seems attractive from a tax point of view, returns are usually capped and it is no substitute for equity funds, say experts.
According to Siddharth Shroff, an MF distributor and advisor, arbitrage funds provide better returns than interest on savings accounts, but returns are usually capped at the 5-6% range.
“From a taxation point of view, investors stand to gain as it is just 10% if you hold it for more than a year. While most of the money was corporate money, retail money has also started flowing in. While it’s a relatively safe instrument given that debt funds are subject to credit risk, it won’t generate as much returns.”
Data from Value Research shows that funds in the category have returned 5-7% over the last one year, and 4-5% over three years.
Following the latest policy announcement by the central bank, analysts see a low possibility of a rate cut anytime soon, and not before the first quarter of the next fiscal year.
“Arbitrage category competes with money market funds, with returns in similar territory. Money market schemes were not getting money for years as long-duration funds were preferred; the transactional money was going into the ultra-short and overnight funds,” says Alok Singh, CIO at Bank of India MF.
He agrees that an upward bias in rates remain, and the RBI may be forced to follow the Fed’s action in forthcoming policy meets, which could have a negative mark-to-market (MTM) impact on liquid funds.
Essentially, a favourable tax regime and low incidence of an M2M impact add to the sheen of arbitrage funds. Singh adds that this is an instrument to park “contingency money”, which is why it has been popular among HNIs and institutional investors. There is no “default risk”, he says, as the counter-party in this case is the exchange.
“While the 10% tax rate applies only after a year, a three-four month horizon, or in some cases six months is also ideal. But one needs to be careful not to have to short a timeline, so that they’re not hit by the volatility between expiry dates,” he pointed out.