Making the best of market volatility

Arbitrage schemes can give investors better post-tax returns than debt funds

If you are an investor who is worried about investing in debt funds, in the wake of Amtek Auto’s defaulting on bond repayment, you can consider arbitrage funds to park short-term money - for a period of three months to two years.

“Though they are classified as equity mutual funds, the risk profile of these funds is similar to those of liquid plus schemes. Their post-tax returns work out to be slightly better. That’s why they are best suited for conservative investors looking at moderate returns from market in a tax efficient way,” said Vidya Bala, head of mutual fund research at Fundsindia.com.

The average returns from arbitrage funds in the past year are 8.25 per cent. In this period, the best fund has delivered 9.23 per cent, while the lowest return is 7.4 per cent. The average return of short-term debt funds is 9.64 per cent ,while liquid fund category average is 8.34 per cent, according to Value Research. In the same period, the BSE Sensex fell 3.3 per cent.

For taxation purpose, arbitrage funds are treated like equity schemes. If a person remains invested for a year, there’s no tax. In debt fund, however, a person needs to remain invested for three years to pay lower tax (long-term capital gains). For an investment tenure below this, the profit is clubbed with the income and taxed according to the prevailing slab.



For a person in the 30 per cent tax bracket, one-year average return of arbitrage funds, therefore, will work out to be 8.25 per cent. But for short-term debt funds, it will be 6.64 per cent and for liquid, it will be 5.34 per cent.

Arbitrage funds take advantage of the stock price difference between cash and derivative segments. For example, if a stock is trading at Rs 100 in the cash market and is quoting Rs 101 in the futures, the fund managers take advantage of this discrepancy. The higher the volatility, the wider is the price difference called as spreads.



Bhavesh Jain, fund manager at Edelweiss Asset Management Company, says he expects the volatility in the market would continue at least until the end of the current calendar year. “The clarity will only emerge after the second and third quarter results, which will give a clearer picture of where the economy is headed,” says Jain. While these schemes invest in equities, they don’t carry the risk of stock market fluctuations, as their returns are not affected by market movement.

Dhaval Kapadia, director – investment advisory, Morningstar Investment Adviser, says they are also tax-efficient for investors who are looking at parking their funds for three months to a year. “These investors can opt for a dividend payout option, as there’s no tax on dividend from an equity fund,” says Kapadia. Also, most of these schemes have a lock-in period of 90 days.

Bala says those investing in these schemes should understand derivatives as the strategy fund managers use is complex. She also cautions that with their popularity, many variations of arbitrage funds have been launched. Some of these keep a small portion in stocks without hedging them – like a typical equity mutual fund. This is done to generate higher returns. But if you are looking at arbitrage funds as a replacement for debt, you should stay away.

Jain of Edelweiss AMC says the best way to pick these funds is to look at the past three months’ performance. “As the inflow in this category is on a rise, everyone chases the same opportunity. This can lower the returns. In the past six months, the assets under management have risen from about Rs 11,000 crore to around Rs 30,000 crore.”