Should you invest in arbitrage funds?
Simply put, you buy a stock in the mazuma market and you book an whop sale of it in the futures market where it is stuff quoted for a higher price. By locking the price in advance, you lock your return as well.
Essentially, this is what arbitrage funds do.
An arbitrage fund exploits price differential between mazuma and future markets using stocks or commodities as an underlying investment. In the process, this limits the upside return since the selling price is pre-determined.
Isn’t that good? May be not.
Let’s understand arbitrage funds a little more.
First a few facts well-nigh Arbitrage Funds
One, the typical portfolio of an arbitrage fund constitutes of stocks, future contracts, debt and money market investments. Since they invest in a combination of investments, they are hybrid in nature.
Two, the benchmark of most arbitrage funds is a liquid fund index. What it ways is that they intend to match returns of a liquid or ultra short term debt fund.
You ask – “why does a fund that invests predominantly in probity and probity related investments produces returns of debt investments?”
Worse, why do you take the risk of an probity investment and still get debt like returns? The next fact answers your question.
Three, the tax treatment of an arbitrage fund is like equity. Without 1 year of holding, you don’t have to pay any long-term wanted gains tax. And short term, that is less than 1 year, proceeds is taxed at only 15%.
This is the single biggest reason for investment in arbitrage funds. Though you earn debt-like returns, they are tax-free without 1 year. For those in the highest tax bracket, this is a huge incentive.
No wonder, many investors are pouring money into arbitrage funds, specially for short term.
Questions –
- Should you really invest in these funds?
- Is the tax goody so large?
- Can you just stick with the debt funds?
Let’s do a comparison.
A comparison of Arbitrage Funds, Ultra Short Term and Liquid Funds
In the pursuit table, we have compared some of the popular arbitrage funds withal with ultra short term and liquid funds.
Source: Unovest Research; All scheme data is for uncontrived plans and as on Dec 30, 2022. Best and Worst performance is for any 12 month period in the fund’s existence. All returns are in %.
Purely on the understructure of returns, liquid funds and ultra short term funds are doing largest than the arbitrage funds.
Even for the best and worst performance in any 1 year period, the arbitrage funds are not hugely largest than the liquid and ultra short term funds. And they come with lower volatility (the whole up and lanugo movement in prices).
It seems to be a no-brainer as to what you should go for.
But wait. What well-nigh the taxes? Now, that could be a twist.
Let’s consider taxes
The rate of tax workable to short term gains on debt funds is as per your tax bracket. If you are in the highest tax bracket, you pay 30% .
As you are aware, from a tax point of view, debt fund gains are treated as short term if sold within 3 years of purchase.
The rate of tax for arbitrage funds for short term is only 15% any surcharge. The long term (post 1 year), it is 10% surcharge.
It becomes well-spoken that arbitrage funds get a decisive whet on the tax front. With a lower rate of tax (specially for those in the highest tax brackets), they make for a compelling reason.
Remember though, that you have to be invested for at least 6 months in arbitrage funds to goody from it.
Note: If you are doing Systematic transfers, using liquid funds can still be a largest option, given that they don’t scream volatility