Debt-plus-arbitrage FoFs offer tax edge for moderate-risk investors

The new fund offer of UTI Income Plus Arbitrage Active Fund of Fund (FoF) is currently open. Several fund houses have in recent times converted their pure debt funds into debt plus arbitrage strategies.

 

The government took away the indexation benefit of debt funds from April 1, 2023. “This affected retail flows into debt funds. Fund houses are trying to address this issue by coming up with a hybrid format that improves tax efficiency,” says Gautam Kalia, head–investment solutions and distribution, Mirae Asset Sharekhan.

 

How the fund works 

These FoFs invest in a mix of debt and arbitrage funds. “The allocation will be to a debt fund that has a high credit quality and moderate duration. The rest of the portfolio will be in arbitrage. Since it will be a fully hedged equity portfolio, the return is likely to be relatively stable over two years,” says Anurag Mittal, head of fixed income, UTI Asset Management Company.

 

Tax efficiency, flexibility 

These funds offer a tax advantage over pure debt funds. “Instead of being taxed at slab rate, as a pure debt fund is, here investors will be taxed at 12.5 per cent after a holding period of two years. At the same time, the level of risk will not change materially in these funds, provided there is no unhedged equity exposure,” says Joydeep Sen, corporate trainer and author.

 

The fund manager can modify his strategy. “Fund managers (FMs) have the flexibility to switch across the interest-rate cycle. If interest rates are expected to be cut, the FM can switch to a relatively higher duration. When interest rates are low and could rise, the FM can switch to a lower duration,” says Mittal.

 

Return you can expect 

Over a 15-year period, the Crisil Short Duration A2 Index delivered an average two-year rolling return of 7.7 per cent, while the Nifty 50 Arbitrage Index returned 6.2 per cent. “A blended portfolio of 64 per cent in debt and 36 per cent in arbitrage would offer a return of 7.2 per cent for a short-duration-plus-arbitrage index. After applying a tax rate of 12.5 per cent, the return comes to 6.3 per cent, according to the historical simulation,” says Mittal.

 

Arbitrage funds generally track liquid fund returns, while debt fund performance varies with interest-rate movements. “The post-tax return from this fund is likely to be better than that of a pure fixed income strategy in case of an investor in the higher tax bracket,” says Mittal.

 

Sen says that arbitrage funds tend to do well in a volatile, non-trending market while debt funds do well when there is a mark-to-market component over and above the accrual gain.

 

Risks and limitations 

These funds can also underperform in certain environments. “When rates are rising, the debt portion could give negative returns for a short while,” says Arnav Pandya, founder, Moneyeduschool.

 

Credit quality also matters. “If the fund manager invests in lower-grade papers, the fund would carry higher credit risk,” says Kalia.

 

Stable markets can reduce arbitrage opportunities. “Returns from arbitrage funds can drop to 4 per cent when spreads are low. There is always the risk of delays, errors and system failures in executing trades,” says Kalia.

 

The redemption timeline will be longer here. “The redemption cycle of a typical debt fund is T+1. Here, since there is an arbitrage element, the redemption cycle could be T+2 or T+3, depending on the fund strategy,” says Mittal.

 

Pandya warns that returns could be slightly higher due to the FoF structure.

 

Check if these funds are right for you

 

• These funds are suitable for investors in higher tax brackets as they are more tax-efficient than debt funds (where investors are taxed at slab rate)
• Investors must have a horizon of two years or more
• They must have some tolerance for mark-to-market volatility in the near term
• Go for them if you have at least a moderate risk appetite