At a time when the markets regulator has made it mandatory that all debt securities with maturities beyond 30 days will be subject to daily mark-to-market (MTM), arbitrage funds are becoming popular with savvy and high risk-taking investors. However, investors should ideally stay invested for a long time so that the market volatility evens out in arbitrage funds. And those who may need money in the short term, should continue to invest in liquid funds.
Before the new norms came into place from April 1 this year, only securities beyond 60 days were subjected to MTM and most liquid fund portfolios were immune to small yield changes. But now, all securities beyond 30 days are being subject to daily MTM and a higher proportion of the portfolios will be revalued daily. Experts say this will result in higher deviation of daily returns from the net YTM of the fund.
What are arbitrage funds?
Arbitrage funds are a category of mutual funds that leverage the price differential between equity shares in the cash market and in the stock futures market. They usually generate returns by harnessing the price differential between the two as they buy in the cash market and sell in the futures market. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives market and the difference in the cost price and selling price is the return that the investors earns.
Typically, the price of a stock in the derivatives market quotes at a premium to its price in the cash market. In fact, this allows for an arbitrage opportunity which such funds attempt to encash by buying a stock in the cash market and selling it in the futures market thereby earning the differential premium between the two prices.
In volatile markets, the returns on arbitrage funds are high. The net asset value (NAV) in arbitrage funds can be very volatile as they value both their buy and sell positions on a MTM basis. However, arbitrage funds can give reasonable returns to those investors who can understand it and then make the most of it.
Experts say arbitrage funds can be a good substitute for savings accounts, ultra-short term and short term debt funds for a horizon of six to 12 months because of liquidity provisions and higher returns.
Tax-savvy investors started investing in arbitrage funds since2014 when the government increased the long-term holding period for debt funds from one to three years. Usually, arbitrage funds invest about 65% of the portfolio in equities and are treated as equity funds from tax purposes. The balance is invested in money market or debt instruments.
From April last year, long-term capital gains from equity funds is taxed at 10%. The short-term capital gains tax for a holding period of less than one year is 15%. It makes sense to invest in arbitrage funds if one has an investment horizon of more than a year. Also, investing a lump sum investment would be better than systematic investment plans in arbitrage funds. They are suitable for investors who are in higher tax brackets to earn tax-efficient returns.
Joydeep Sen, founder of wiseinvestor.in, says arbitrage funds have a tax advantage over debt funds as it is an equity fund for tax purposes. However, to arbitrage funds can be much more volatile than liquid funds in the short term. For a horizon of six months to one year, arbitrage funds offer tax efficiency and reasonably stable returns compared with liquid funds, he says.