MF industry leverage fund-of-fund route to create debt alternative

Fund houses adding arbitrage to existing debt FoFs to get the tax advantage

In the quest for a tax-efficient debt fund alternative, the mutual fund (MF) industry is knocking on the doors of Fund of Funds (FoF).

 

Currently, there are two FoFs that allocate a portion of their assets to arbitrage funds to improve tax efficiency. Two more additions will happen by March 3.

 

Kotak Mutual Fund was the first to introduce this approach by adjusting the asset allocation framework of its Kotak All Weather Debt FoF in October 2024, renaming it the Kotak Income Plus Arbitrage Fund.

 

Recently, Bandhan MF, Axis MF, and Aditya Birla Sun Life (ABSL) MF have followed suit.

 

In response to the changes in taxation, the MF industry has been actively exploring ways to create low-risk, tax-efficient alternatives to traditional debt funds. Debt funds, which have traditionally been favoured for short-term investments due to their low risk and predictable returns, lost their indexation benefit in 2023.

 

As a result, gains from debt funds are now taxed according to the investor's income-tax slab rate, regardless of the holding period.

 

However, changes in the FoF tax structure in 2024 have opened the door for more tax-efficient debt-oriented FoFs.

 

Any FoF that invests at least 35 per cent in equities (including equity arbitrage) now qualifies for long-term capital gains (LTCG) tax treatment. This means gains are taxed at 12.5 per cent if the investor holds the investment for more than two years.

 

All the four FoFs that have added equity arbitrage to the mix plan to allocate around 35-40 per cent to arbitrage funds and the rest to debt funds.

 

"Kotak Income Plus Arbitrage FoF ensures that the exposure to debt-oriented mutual fund units, money market instruments, triparty repo on government securities or treasury bills, cash, and cash equivalents remains below 65 per cent at all times. Gains on investments held for over 24 months will now qualify as long-term capital gains (LTCG) and be taxed at a flat rate of 12.5 per cent. This shift significantly enhances tax efficiency for long-term investors by reducing tax liability and positioning the fund as a more favourable alternative to traditional debt-oriented funds," said Deepak Agrawal, CIO-Debt, Kotak Mahindra AMC.

 

Bandhan MF, Axis MF, and ABSL MF have introduced similar products by changing the fundamental attributes of their existing debt FoFs. Bandhan MF's All Seasons Bond Fund changed to Bandhan Income Plus Arbitrage FoF on January 28.

 

Axis All Seasons Debt FoF is set to become Axis Income Advantage on February 14 and ABSL Active Debt Multi Manager FoF is on course to become ABSL Debt Plus Arbitrage FoF from March 3, 2025.

 

HDFC MF had sought the Securities and Exchange Board of India's approval for a similar fund — HDFC Debt Advantage FoF — in September 2024. However, it is yet to be launched.

 

Experts said the offering is suitable for investors having a positive outlook on debt. However, they need to be mindful of the underlying assets of the debt funds that the FoFs invest in and their expense ratios which can be on the higher side.

 

“Such offerings can find a place in investor portfolios, given the tax advantage. However, much will depend on the debt funds they invest in and how well they are managed. In addition, the expense ratio should be reasonable for the fund to compete with other lower-risk investment options," said Rushabh Desai, founder, Rupee With Rushabh.

 

After the change in debt fund taxation, arbitrage funds have been the preferred option for low-risk investments. Experts say that the newly introduced debt plus arbitrage FoF options can be a better option for investors due to their higher return potential, especially during favourable interest rate cycles.

 

"The minimum recommended investment horizon is 2 years, and the FoF has the potential to offer relatively better returns compared to a standalone arbitrage fund," Bandhan MF said. However, arbitrage funds are tax-friendly alternatives as they qualify for LTCG taxation in just a year.