FUND FLAVOUR

March 2019

Low on risk, high on tax efficiency

Is there any investment option which can mimic the risk-return profile of a debt mutual fund and is also a tax efficient one like an equity oriented mutual fund? The answer is “yes”. An Arbitrage mutual fund is similar to say a liquid fund in terms of returns and is like an equity fund with respect to tax implications. It is generally a risk-free investment option. Arbitrage Funds work on the mispricing of equity shares in the spot and futures market. Essentially, it exploits the price differences between current and future securities to generate returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives market. The difference in the cost price and selling price is the return you earn. This category of funds does not take a naked exposure to any individual company or an index as each buy transaction in the cash market has a corresponding sell transaction in the futures market. They make money from low-risk buy-and sell opportunities available in the cash and futures market and their risk profile is similar to that of a debt fund. In fact, many arbitrage funds use Crisil Liquid Fund Index as their benchmark. Its investment strategy to generate a return with less risk and taxation benefits has attracted a large number of investors. Arbitrage Funds gains profit from the difference in price of a security in various markets.  Let us explore this fascinating fund in detail.

The Modus Operandi

Suppose the equity share of a company ABC trades in the cash market at Rs. 1220 and in the future market at Rs.1235. The fund manager buys ABC share from cash market at Rs 1220 and sorts a futures contract to sell the shares at Rs 1235. Towards the end of the month when the prices coincide, the fund manager will sell the shares in the futures market and generate a risk-free profit of Rs.15/- per share less transaction costs. Conversely, if the fund manager feels the price to fall in future, he enters into a long contract in the futures market. He will short-sell the shares in the cash market at Rs 1235. At the expiry date, he buys shares in the futures market at Rs. 1220 to cover up his position and earns a profit of Rs. 15. In yet another scenario, the fund manager may buy an equity share for Rs. 100 in National Stock Exchange (NSE) and sell the same at Rs 120 in the Bombay Stock Exchange (BSE) to make a risk-free return. Arbitrage funds leverage benefit of the difference in pricing of the stock between the cash market and the futures market. This is achieved by buying a specified number of stocks from the cash market while the same number of futures contracts is sold simultaneously on the derivatives market if the overall market sentiment is bullish. On the other hand, if the market sentiment is bearish i.e. in case a majority of investors believe that stock prices will drop, the arbitrage fund will price the future contracts at a lower price and sell an equivalent number of shares on the cash market at the current (higher) spot price.

The pros…

Arbitrage funds offer a number of benefits, including:

 

Low Risk

One of the chief benefits of arbitrage funds is they are low risk. Because each security is bought and sold simultaneously, there is virtually none of the risk involved with longer-term investments. In addition, arbitrage funds invest part of their capital into debt securities, which are typically considered highly stable. If there is a shortage of profitable arbitrage trades, the fund invests more heavily in debt. This makes this type of fund very appealing to investors with low risk tolerance.

Another big advantage to arbitrage funds is they are some of the only low-risk securities that actually flourish when the market is highly volatile. This is because volatility leads to uncertainty among investors. The differential between the cash and futures markets is exaggerated. A highly stable market means individual stock prices are not exhibiting much change. Without any discernible bullish or bearish trends to either continue or reverse, investors have no reason to believe stock prices one month in the future will be much different from the current prices.

Volatility and risk go hand in hand. You cannot have huge gains or huge losses without either. Arbitrage funds are a good choice for cautious investors who still want to reap the benefits of a volatile market without taking on too much risk.

 

Taxed As Equity Funds

Though arbitrage funds are technically balanced or considered hybrid funds because they invest in both debt and equity, they invest primarily in equities by definition. Therefore, they are taxed as equity funds since equity represents at least 65% of the portfolio, on average. If you hold your shares in an arbitrage fund for more than a year, then any gains you receive are taxed at the capital gains rate, which is much lower than the ordinary income tax rate.

…and the Cons

 

Unpredictable Payoff

One of the primary disadvantages of arbitrage funds is their mediocre reliability. As noted above, arbitrage funds are not very profitable during stable markets. If there are not enough profitable arbitrage trades available, the fund may essentially become a bond fund, albeit temporarily. This can drastically reduce the fund's profitability, so actively managed equity funds tend to outperform arbitrage funds over the long term.

 

High Expense Ratios

The high number of trades that successful arbitrage fund management requires means the expense ratios for these types of funds can be quite high. Arbitrage funds can be a highly lucrative investment, especially during periods of increased volatility. However, their reliability and substantial expenses indicate they should not be the only type of investment in your portfolio.

 

The key takeaways

• Arbitrage funds can be a good choice for investors who want to reap the benefits of a volatile market without taking on too much risk.
• Though they are relatively low risk, the payoff can be unpredictable.
• Arbitrage funds are taxed like equity funds.
• Investors need to keep an eye on expense ratios, which can be high.

Things to consider

 

a. Risk factor

As trades occur on the stock exchange, there is no counter-party risk involved in these funds. Even when the fund manager is buying and selling shares in cash and futures market, there is no risk exposure to equities as is the case with other diversified equity funds. Though the ride looks smooth, do not get too comfortable with these funds. As more people start trading into arbitrage funds, there will be not many arbitrage opportunities available. The spread between cash and future market prices will erode, leaving little for the arbitrage focused investors.

b. Return

Arbitrage Funds may be a good opportunity to make reasonable returns for those who can understand it and then make the most of it. The fund manager tries to generate an  alpha using price differentials in markets. Historically, arbitrage funds have been found to give returns in the range of 7%-8% over a period of 5-10 years. If you are looking to earn moderate returns via a portfolio which has a perfect blend of debt and equity in a volatile market, arbitrage funds may be your thing. However, you need to keep one thing in mind that there are no guaranteed returns in arbitrage funds.

c. Cost of investment

Cost becomes an important consideration while evaluating arbitrage funds. These funds charge an annual fee called expense ratio , a percentage of the fund’s overall assets. It includes fund manager’s fee and fund management charges. Due to frequent trading, arbitrage funds would incur huge transaction costs and has a high turnover ratio. Additionally, the fund may levy exit loads for a period of 30 to 60 days to discourage investors from exiting early. All these costs may lead to increase in the expense ratio of the fund. A high expense ratio puts a downward pressure on your take-home returns.

d. Investment horizon

Arbitrage funds may be suitable for investors having a short to medium term horizon of 3 to 5 years. As these funds charge exit loads, you may consider them only when you are ready to stay invested for a period of at least 3-6 months. Please understand that fund returns are highly dependent on the existence of high volatility. So, choosing a lump sum investment would make sense over Systematic Investment Plans (SIPs). In the absence of volatility, liquid funds may give better returns than arbitrage funds over the same investment horizon. Hence, you need to keep the overall market scenario in mind while choosing arbitrage funds.

e. Financial goals

If you have short to medium term financial goals, then arbitrage funds are your thing. Instead of a regular savings bank account, you may use these funds to park excess funds in order to create an emergency fund and earn higher returns on them.. In case you were already invested in riskier havens equity funds, then you may begin a systematic transfer plan (STP) from the equity funds to a less risky haven like arbitrage funds as you approach completion of the financial goal. This would reduce your portfolio’s overall risk profile but at the same time reduce the returns also. You cannot expect to earn double-digit returns in arbitrage funds.

f. Tax on gains

These funds are treated as equity funds for the purpose of taxation. If you stay invested in them for a period of up to 1 year, you make short-term capital gains (STCG) which are taxable. STCG are taxed at the rate of 15%. If you stay invested in them for a period of more than 1 year, the gains will be treated as long term capital gains(LTCG). LTCG in excess of Rs.1lac is taxed at the rate of 10% without the benefit of indexation. Instead of sticking to pure debt funds, these funds are suitable for conservative investors who are in higher tax brackets to earn tax-efficient returns.

Points to ponder

·         Arbitrage Funds can generate more and better returns when markets are volatile. The volatile markets can create arbitrage opportunities. But, do not invest in Arbitrage funds with an objective to get double digit returns. The returns at best can be in the range of 5 to 8%.

·         These funds can generate better returns if major portion of fund corpus is invested in mid or small cap stocks or derivatives as they can be very volatile.

·         If you opt for ‘Dividend’ option, then DDT (Dividend Distribution Tax) is not applicable on the dividend declared by the funds. The dividends received from Arbitrage Funds are tax-free.

·         Though these funds mimic debt funds like risk profile but they cannot be considered as pure alternatives to Debt mutual Funds. In a declining interest rate scenario, Gilt Funds or Short-Term Debt Funds or even Dynamic Bond Funds can outperform Arbitrage Funds. In the first half of the 2015, Income Funds or Dynamic Bond funds (Debt funds) & Short-Term debt funds have outperformed the arbitrage funds thanks to the interest rate cuts.

·         Though these funds are treated as Equity funds w.r.t. taxation, they may not generate returns like equity funds in the long-term.

·         If you are looking for a tax efficient investment option for short term goals (1 to 2 year goals), you can consider investing in arbitrage funds.

·         You can invest lump sum amounts in these funds for short-term goals. Systematic Investment Plan (SIPs) in these funds may not really make sense.

·         You can consider these funds as one of the saving options when you are building your emergency fund.

·         When your Financial Goal Target Year is nearing, you can switch from high risk investment options to these funds which have low-risk & are tax-free (more than 1 year).

·         These funds have a very remote chance of generating negative returns. Even in 2008 when stock markets crashed, arbitrage funds gave positive returns in India.

·         As these are risk-less opportunities, the returns may not be double digits.

·         Arbitrage Funds can be a better choice if you are in the tax slabs of 20 to 30%, when markets are very volatile and when the interest rates are stable or increasing.

·         Do watch out for Exit Loads of these funds. They can be higher than the debt funds.

·         Arbitrage Funds are not allowed to SHORT in Cash Markets in India. So in a bear market their performances can suffer.

These funds have high turnover and high transaction costs. (If a fund has 100% turnover, the fund replaces all of its holdings over a 12-month period. This is known as Turnover Ratio.)

Volatility is the name of the game

Volatility is good news for investors in arbitrage funds as their returns go up during periods of market turmoil. This is because arbitrage funds generate returns by harnessing the price differential between the cash and futures market— they buy in the cash market and sell in the futures market. This cash-futures difference widens during volatility. Of late, average absolute returns from arbitrage funds have jumped and in September 2018 it was at 0.7514% (9% annualised). Average returns have jumped from 5.79% in September 2017 to 9.02% in September 2018.Two factors contributed to this jump. First was the increased volatility in the market. Experts feel returns from this category will be strong in the coming months as well. Increased volatility will continue till the general elections in 2019 and arbitrage funds should continue to generate good returns. Increased currency volatility and high hedging cost of dollar is the other reason. The rupee has already weakened to 74 – 75 per dollar and experts do not see further depreciation. However, that does not mean that FPIs will come back with a bang, because the currency hedging costs would remain high for some more time. However, the additional returns from this factor may not last till May 2019—FPIs will come back once currency hedging costs stabilise, reducing arbitrage opportunity for domestic funds. Investors should thus moderate their return expectations. The returns generated in the last 1-2 months were high and investors should not expect similar returns for the full year. Exit load can eat into short-term returns. These schemes cannot be substitutes for liquid investments. 

Answers to pertinent questions

Who should invest?

Arbitrage funds are useful for investors with low risk appetite. However, investors who want to get into this segment should also realise that its NAV volatility can be very high in the short term. This is because the scheme will be forced to value both their buy and sell positions on a mark to market basis. Though locked-in profit will be realised finally (when the arbitrage trade is finally settled), this valuation method, may force it to report short-term losses if the gap widens in the middle. Arbitrage funds are suited for educated investors, who understand how they work. They also need to understand that returns will be high during high volatility periods and will be low during low volatility.

Safe haven

Arbitrage funds make money from low-risk buy-and-sell opportunities available in the cash and futures market. Their risk profile is similar to that of a debt fund. In fact, many arbitrage funds use Crisil BSE 0.23% Liquid Fund Index as their benchmark. These funds are tailor-made for investors who seek equity exposure, but are wary of risks associated with them. Arbitrage funds become a safe option for the risk-averse individuals to park their surplus money, when there is a persistent fluctuation in the market.

Taxation advantage

Though they offer debt-like returns, arbitrage funds are treated as equity funds for taxation purposes. While the taxation advantage is less now after the imposition of long term capital gains tax and dividend distribution tax, they still offer an edge if you park funds for short to medium durations. Since the risk here is low, people can shift their debt fund investments to arbitrage funds for better post tax returns.  Arbitrage funds offer a tax advantage and therefore, the post tax returns are better. However, your holding period is critical. Arbitrage funds are good if your holding period is less than three years. This is because three years is the cut off between short-term capital gain (taxed at your tax slabs) and long-term capital gain (taxed at 20% after allowing indexation benefits) in debt funds. 

Growth or dividend?

This is the next question investors need to answer once they decide to go with arbitrage funds. Investors with a holding period of up to one year can go with the dividend option. They can opt for the growth option if their holding period is between one and three years. 

Exit load

Since NAV movements can be volatile within monthly derivative cycles, fund houses usually charge small exit loads for redemptions within a month. Investors should not use equity arbitrage funds as a substitute for liquid funds to park money for a few days. 

Why is there higher investor interest in arbitrage funds? 

There is higher interest amongst investors in arbitrage funds ever since the long-term holding period for debt funds was increased from one to three years. Since arbitrage funds maintain an average exposure of more than 65% to equity, they are treated as equity funds, their holding period for long-term capital gain is one year. From the start of April 2018, long-term capital gain from equity is taxed at 10%. 

Is Arbitrage safe strategy for investors?

Wealth managers point out that arbitrage funds rank high in the pecking order when it comes to safety. The fund manager creates a market neutral position by buying in cash market and selling in futures. Higher the volatility, higher the opportunities. With elections around the corner, volatility will increase and hence they are a good bet. 

What returns have these funds generated in the past?

Returns from arbitrage funds depend on arbitrage opportunities available between the spot market and the futures market. Such opportunities are high in bull markets. As the assets under management in this segment increase, all this money will be chasing similar arbitrage opportunities and hence returns could be lower. Over the last one year, this category of funds has given an average return of 5.65%. Over a three year period investors have earned a return of 6.10%.  The current FD rates for 1 to 2 year tenure are around 6 to 7%. But Arbitrage funds are more tax efficient than FDs. So, if you are planning to invest in FDs (time deposits) for short term, you may still consider investing in Arbitrage Funds. Arbitrage funds have given average returns of 5 to 6% in the past one year, while liquid and short-term funds have given around 6.5% and fixed deposits have yielded 6.75%. Investors in the 5% tax bracket might not find this very attractive, but those in the 20% and 30% tax brackets certainly will. In the 30% tax bracket, the post-tax yield of debt funds will be around 4.5% while bank deposits will give roughly 4.75%.  

If you look at the returns of arbitrage funds, they do not seem very attractive when compared to the pre-tax returns of liquid funds or short-term debt funds. However, it is the tax implication that makes the difference. When considering the 1-year returns, the gains on arbitrage funds are tax-free. However, returns on liquid funds and short-term debt funds attract a tax rate of nearly 36% if you fall in the highest tax bracket. In most of the periods, Arbitrage Schemes outdid the debt fund benchmarks, if we consider the taxability as per the current rules. Thus, for short-term investments, arbitrage schemes are a clear winner. For investments greater than three years, indexation kicks in. Thus, the effective tax rate would be lower than 20%. Hence, debt schemes may be able to deliver a better post-tax return as compared to arbitrage schemes. On considering the past three-year returns on a yearly basis, we can see that debt fund indices have clearly outperformed the average arbitrage fund. Individual debt schemes would have performed much better. However, in a couple of three-year periods ending September 2012 and September 2013, arbitrage schemes performed marginally better than their debt fund counterparts. From the above analysis, we can say that arbitrage schemes are an apt choice if your holding period is less than three years. The difference in taxation makes a significant transformation in the net returns. Like with all investment avenues, you need to choose wisely.