Experts suggest investing in arbitrage funds to beat tax woes

Everybody is in with love arbitrage funds since the Union Budget was announced last Thursday. Soon after the finance minister changed the tax treatment on long-term capital gains on nonequity funds, many experts have started exhorting investors to take a close look at arbitrage funds to earn better post-tax returns. Long-term capital gains tax on non-equity funds has been hiked to 20 per cent from 10 per cent. The lock-in period has also been increased to 36 months from 12 months.

Arbitrage funds, on the other hand, are treated like equity funds and enjoy lower capital gains tax, as returns on investments up to 12 months are taxed at 15 per cent and there is zero tax on investments held for more than a year.

“Arbitrage funds buy and sell securities at the same time. They have market neutral positions and carry negligible risk,” says Lakshmi Iyer, chief investment officer (debt) and head of products, Kotak Mutual Fund. She asks investors to consider investing in arbitrage funds with a horizon of three months.

Arbitrage funds have returned 9.4 per cent in the last year, says Value Research, a mutual fund tracking firm. However, experts warn the returns could be lower in the coming days. “Higher flows into arbitrage funds, could lead to more money chasing the same opportunity, which will reduce returns,” says Harshvardhan Roongta, chief financial planner, Roongta Securities.
How Do They Work?

Arbitrage funds look to exploit arbitrage opportunity (the price difference in securities) in different segments of the markets. For example, these funds look at arbitrage between cash and future markets. Fund managers feel that there are significantly higher arbitrage opportunities in a bull market. “In a rising market, inves tors are more likely to pay a higher premium for carrying forward their leveraged positions, which creates a higher spread,” says Chintan Haria, fund manager, ICICI Prudential AMC.

For instance, there could be a difference between a stock’s price in the cash market and the futures market, or between two exchanges like the BSE and the National Stock Exchange (NSE). On July 1, a fund manager will buy 1,000 shares of, say, Reliance Industries in the cash market trading at Rs 990 a share, and sell an equivalent quantity in the futures market at Rs 1,000 a share. Thus, the fund manager earns a spread of Rs 10 per share or 1.1 per cent. At the end of the contract, the price of Reliance in the cash and future market will converge. Assume the fund manager, reverses both trades on July 30, atRs 1,050, the net profit is Rs 10 (1.1 per cent) less his broking charges and STT charges, which is 0.33 per cent. Thus the fund manager’s arbitrage profit in the trade is 0.77 per cent (1.1 per cent minus 0.33 per cent) or an annualized 9.24 per cent.

Be Ready to Face Volatility

Arbitrage funds could face some volatility, as the price of a security in either the cash or futures market could move up or down due to the volatility in the market before the expiry. Since the NAV (net asset value) is calculated on a markto-market basis, there could be mark-to-market losses in the interim period. That is why, experts recommend investing with a minimum time frame of 90 days.

Most arbitrage funds typically charge an exit load for a period of 90 days due to this reason. For example, IDFC Arbitrage Fund charges an exit load of 0.25 per cent for 90 days, while Edelweiss Arbitrage Fund and ICICI Prudential Equity Arbitrage Fund charge 0.5 per centfor 90 days.