Why arbitrage funds are gaining traction among investors?

ARBITRAGE FUNDS ARE BECOMING POPULAR IN INDIA

One of the fund categories that is attracting a lot of attention from institutions and HNIs is arbitrage funds. Any arbitrage funds typically buys in equity and sells in stock futures. Here are the flows into Arbitrage funds in last 6 months; and as a proportion of hybrid funds.

Data Source: AMFI

In the last 6 months, arbitrage funds have accounted for between 60% and 70% of overall hybrid fund flows and averaged 67.3% for the 6 months overall. Here it must be noted that while arbitrage funds are classified as hybrid funds by AMFI, they are structurally similar to liquid funds. The arbitrage spreads are similar to the returns on a liquid fund. However, there is one difference. The arbitrage fund returns can be higher than liquid funds if the volatility in the equity markets is high. That is one reason why the yields on arbitrage funds tend to be more attractive in volatile market conditions.

RETURNS COMPARISON – ARBITRAGE FUNDS VERSUS LIQUID FUNDS

Here is a look at the best performing arbitrage funds and the best performing liquid funds in last 1 year. We focus on 1-year returns, as that is more relevant for short-term investments.

Data Source: Morningstar India (NAV as on 04-July)

The above table captures top-8 ranked funds in the arbitrage funds category and the liquid funds category. One similarity you find is that the returns of the top-8 arbitrage funds and the top-8 liquid funds are almost comparable and even the averages of the top-8 show little dispersion. Where arbitrage funds score is that even if you consider the entire universe of arbitrage funds, the dispersion is not to high. In the case of liquid funds, if entire universe of liquid funds is considered, then the average dips quite sharply.

However, the biggest advantage that these arbitrage funds enjoy is the tax treatment. While a liquid fund is treated as a pure debt investment, the arbitrage funds are treated as equity investment for tax purposes. So, how that make a difference?

HOW TAX TREATMENT MAKES THE BIG DIFFERENCE?

To understand the comparative tax treatment that makes arbitrage funds attractive, let us look at the example of an HNI; who invests ₹50 Lakhs in arbitrage funds and ₹50 Lakhs in liquid funds too. Here is how the tax treatment compares.

Case 1: Arbitrage Fund

The average return on top-8 arbitrage funds is 7.574%. So, on the investment of ₹50 Lakhs, the long-term capital gains earned is ₹3,78,700. Out of this ₹1,25,000 will be available as base exemption, so the taxable LTCG will be ₹2,53,700. This will attract LTCG tax at 12.5%, so the tax impact will be ₹31,713, and the post-tax gains would be ₹3,46,987. That translates into post-tax yield on the arbitrage fund of 6.94%.

Case 2: Liquid Fund

The average return on top-8 liquid funds is 7.199%. So, on the investment of ₹50 Lakhs, the capital gains earned is ₹3,59,950. Being a debt fund, this will be taxed at the peak rate applicable. Let us assume his peak tax rate is 31.2% (including cess). This will translate into tax impact of ₹1,12,304, and the post-tax gains would be ₹2,47,646. That translates into post-tax yield on the liquid fund of 4.95%.

The above comparison exhibits that, in post-tax terms, the arbitrage fund has an advantage of nearly 200 basis points. In addition, investors are also expecting the liquid fund yields to come down as markets turn into surplus liquidity and repo rates have been cut. In short, a combination of factors have been favouring arbitrage funds over liquid funds.