Why arbitrage mutual funds score over debt funds
ET CONTRIBUTORS|
Oct 23, 2017, 06.30 AM IST
By D.P. Singh
The Nifty is trading over 26.25 times its trailing 12-months earnings, which appears relatively stretched compared to historical valuations.
While equity funds may appear risky at this juncture, there is one category of equity funds that stand out as relatively free of risk. Whether markets are shooting up or sliding down, arbitrage funds will almost always generate positive returns.
How do these funds manage to do this? Simple, the fund grabs the arbitrage opportunity that lies in the difference between the cash and future prices of stocks. The fund manager will buy a stock for Rs 1,000 from the cash market, and sell futures of the same stock in the derivative market for Rs 1,080. The Rs 80 difference in the cash and future prices will be the profit of the fund from this transaction. On the day of the expiry of the futures contract (last Thursday of every month), the fund manager squares the two transactions by selling the stock and buying the futures contract.
Hence, irrespective of whether price of the stock moves up or goes down, the difference in the price is pocketed by the fund. Investors will find the tax treatment of arbitrage funds especially attractive. Since these funds maintain an average equity exposure of more than 65%, they get the same tax treatment as equity funds. Short-term gains are taxed at 15% while long-term gains (holding period of one year or more) are tax free.
What’s more, the dividend income doesn’t attract dividend distribution tax. All this makes arbitrage funds a better alternative to debt funds in the short-term (holding period of 1-2 years). Arbitrage funds have given average returns of 6% in the past one year, while liquid and shortterm funds have given 6.5% and fixed deposits have yielded 6.75%. Investors in the 5% tax bracket might not find this very attractive, but those in the 20% and 30% tax brackets certainly will. In the 30% tax bracket, the post-tax yield of debt funds will be around 4.5% while bank deposits will give roughly 4.75%.
The 6% tax-free return from arbitrage fund looks more attractive in comparison. In fact, investor interest in arbitrage funds increased after the long-term holding period for debt funds was raised from one to three years. In July and August this year, the mutual fund industry witnessed a huge inflow of Rs 31,500 crore in equity funds. But more than a third of this (Rs 11,500 crore) was in arbitrage funds. It is time you also considered investing in this relatively safe and taxefficient category of mutual funds.
(The author is Executive Director and Chief Marketing Officer, SBI Mutual Fund)
The Nifty is trading over 26.25 times its trailing 12-months earnings, which appears relatively stretched compared to historical valuations.
While equity funds may appear risky at this juncture, there is one category of equity funds that stand out as relatively free of risk. Whether markets are shooting up or sliding down, arbitrage funds will almost always generate positive returns.
How do these funds manage to do this? Simple, the fund grabs the arbitrage opportunity that lies in the difference between the cash and future prices of stocks. The fund manager will buy a stock for Rs 1,000 from the cash market, and sell futures of the same stock in the derivative market for Rs 1,080. The Rs 80 difference in the cash and future prices will be the profit of the fund from this transaction. On the day of the expiry of the futures contract (last Thursday of every month), the fund manager squares the two transactions by selling the stock and buying the futures contract.
Hence, irrespective of whether price of the stock moves up or goes down, the difference in the price is pocketed by the fund. Investors will find the tax treatment of arbitrage funds especially attractive. Since these funds maintain an average equity exposure of more than 65%, they get the same tax treatment as equity funds. Short-term gains are taxed at 15% while long-term gains (holding period of one year or more) are tax free.
What’s more, the dividend income doesn’t attract dividend distribution tax. All this makes arbitrage funds a better alternative to debt funds in the short-term (holding period of 1-2 years). Arbitrage funds have given average returns of 6% in the past one year, while liquid and shortterm funds have given 6.5% and fixed deposits have yielded 6.75%. Investors in the 5% tax bracket might not find this very attractive, but those in the 20% and 30% tax brackets certainly will. In the 30% tax bracket, the post-tax yield of debt funds will be around 4.5% while bank deposits will give roughly 4.75%.
The 6% tax-free return from arbitrage fund looks more attractive in comparison. In fact, investor interest in arbitrage funds increased after the long-term holding period for debt funds was raised from one to three years. In July and August this year, the mutual fund industry witnessed a huge inflow of Rs 31,500 crore in equity funds. But more than a third of this (Rs 11,500 crore) was in arbitrage funds. It is time you also considered investing in this relatively safe and taxefficient category of mutual funds.
(The author is Executive Director and Chief Marketing Officer, SBI Mutual Fund)
