Last week I was discussing with a small group of friends about safe and tax efficient short-term investment avenue to park surplus money other than the fixed deposit, and the answer was “Liquid Funds are the best for a short-term investment”. After hearing the answer, I was stunned because I was expecting answer “Arbitrage Fund”. Still, many of us believe that Liquid Funds are the best alternative to Fixed Deposit. What is your answer? If your answer is ‘Yes’ then you must read the complete article. In the end, you will understand why Liquid funds are not tax efficient short-term investment avenue.
As an Investor sometimes we follow advice blindly without doing proper homework. Debt mutual funds were a perfect substitute for the bank fixed deposit because they offer much higher post-tax return than FD. But remember after July 10, 2014, budget announcements, Liquid Funds are no more tax efficient as it was.
Debt mutual funds have suddenly lost attention from the short-term investor. Having said that, Liquid Fund haven’t impacted so badly even through the tax advantage was gone, the convenience and better absolute returns from the Liquid Fund for very short-term, even for overnight investing is very significant.
The reason; honourable Finance minister changed the tax provision for debt mutual funds in his very first budget. Now, debt mutual fund will enjoy the benefit of Indexation but you have to be invested for the 3 years. Many Investors may have some misunderstanding even after almost one year of the budget announcement, they still think Liquid Funds are best.
So, now you will ask, show me a substitute that could offer equal post-tax returns and with almost same capital protection. So to clear this ambiguity among the investor for a short-term investment avenue, today we will explore very less heard category of mutual fund “Arbitrage Fund”. We will understand how tax efficient they are and is it right fund to park your money for the short-term?
What is Arbitrage Fund?
Arbitrage Fund is a category of mutual fund that leverages the price differential in the cash and derivatives market to generate returns. The returns are directly dependent on the volatility of the asset class.
The overall risk the Scheme would carry would be that of being market neutral i.e. No specific equity risk.
These funds are hybrid in nature as they have the provision of investing a small part of the portfolio in debt markets.
Arbitrage Funds are mainly for low risk-taking investors. In a situation of high and persistent fluctuation, Arbitrage Funds offer investors a safe opportunity to park their hard-earned money. These funds take advantage of the Equity market inefficiencies and secure profits for the investors like you and me. These funds invest primarily in equities; their tax treatment is same as equity mutual funds.
How Arbitrage Fund generate returns?
So, you will ask what arbitrage opportunity is? To understand in a very simple term, Difference between cash segment stock price and future segment (F&O) is referred as an arbitrage opportunity. You will ask why this difference is, and to answer your query it is due to insufficient flow of information between two market prices and it is temporary in nature. Sometimes due to huge buying/selling in the particular segment of stock or huge volatility in market generates arbitrage opportunity.
For example, Due to some stock specific news like quarterly or annual results, corporate governance issue, bulk buying or panic selling generates arbitrage opportunity because of the relative price difference in cash and future market. Generally Arbitrage Fund uses hedging strategy; they buy stock from cash market and sell those stocks in the future market to lock price difference between two segments of the market.
Arbitrage strategies followed are different for different asset management companies; some may adopt strategies like Index/Stock cash – Index/Stock future, ADR/GDR, Buy-Back Arbitrage, Hedging and Alpha strategies, cash-future arbitrage strategies or corporate action or event driven strategies. When fund manager feels market having very less volatility or arbitrage opportunity, he may invest a sizeable amount in debt or money market securities to generate stable returns.
An example of Arbitrage opportunity.
Assume that price of ABC stock is quoting at Rs. 500 in the cash segment, whereas the price in the Future market is Rs. 510. At this point of time fund manager, can make the profit by purchasing stock in cash segment and selling an equal number of shares in the future market. So after doing this translation fund manager locks in Rs 10 profit per share on the day of settlement without getting worried about daily price movement or market directions.
Investment done is the cost paid for cash market buy and margin value of the future contract. Profit will be booked on the day when stock price of both the market match or on the last day of settlement and the fund manager will reverse his position in stock, he will sell stock holding in cash segment which was purchased and will buy contract in the future segment.
Mostly returns generated by schemes are based on the efficiency of fund manager’s opportunity spotting skill and trade execution skill of his team.Cash price and Future contract price generally converges at the end of the month, so he will make very low risk return of around 12% [(510-500)*12/100].
Looking at one-year performance and return generated by the Liquid Fund, Liquid fund category generated an average return of 8.4% for the period of 1 year against 8.2% return generated by Arbitrage fund category (Data credit- VRO 21/09/2015). Looking at the return generated in the same period, Liquid fund scores above Arbitrage fund for the said period and for the period of 2 years, 3 years and 5 years.
Comparison of Liquid Fund and Arbitrage fund returns
Comparing the top performing fund of both the schemes, Liquid Fund again giving tough competitions to Arbitrage Fund for different time horizon, the Liquid Fund outperformed in all four different time horizons by the margin of 0.1% to 0.8%. Well, Liquid Fund is again a winner in terms of outperformance for the given period.
When we were comparing the worst performing funds of both the category, the result was surprisingly different. Here Arbitrage Fund performed better, even in absolute terms Liquid Fund were beaten down with the wider margin, ranging from 0.8% to 1.3%. So, surprisingly Arbitrage Fund is the winner in the case of a worst performing fund.
Please remember we have compared pre-tax returns. Let’s have a look on tax treatment for the debt and equity mutual funds.
Post Tax Returns
We have compared the performance of both schemes for the period of 1 year, 2 years, 3 years and 5 years in the section of the fund performance and winner was Liquid Fund. Let’s have a look on post-tax return figure before declaring the winner. (For simplification we haven’t added cess in income tax calculation).
As an investor, we are choosing the Liquid Fund or Arbitrage Fund to park our money for a very short period. Let’s have a look on a post-tax return for different investment time frame.
Post Tax return of Liquid fund
Looking the above post-tax return chart, Individuals who are in 10% tax category, Liquid Fund returns are in your favour compare to Arbitrage Fund returns and that is because of tax treatment on a capital gain. But for investors, who are already paying 20% or 30% income tax, due to the adverse tax treatment of debt mutual fund, your actual post tax earning will be very less than what you are expecting before investing your money.
Let’s take an example of individuals who are paying 30% income tax. Investing in Liquid Fund for the period of 6-month to park surplus money. After six months of investment, his post-tax return would be much lower compared to return generated by Arbitrage Fund. He will be earning merely 2.4% post-tax return from the Liquid Fund scheme against 3.4% post-tax return from Arbitrage Fund.
The difference in earning is around 1%, which is almost 41% higher than Liquid Fund returns considering actual gain after tax treatment, and same is true for the 1-year time frame. Post-tax return generated by the Liquid Fund for the period of one year is 5.9% against 8.2% of Arbitrage Fund, which is significantly higher than the Liquid Fund.
It is clear that by selecting the correct investment vehicle considering time frame and individual’s tax bracket, one can reap significantly higher returns than blindly following advises without doing own homework.
Let us take one example, Mr. A and Mr. B both are a good friend and working in same organisation paying 30% income tax. Now both wants to park surplus amount 10 Lakhs for the period of 1 year. Mr. A picked Liquid Fund and Mr. B picked Arbitrage Fund. After 1 year of investment, post-tax return generated by Mr. A is around Rs. 59,000/- and for Mr. B it is around Rs. 82,000. So by investing wisely Mr. B earned Rs. 23,000 more, which is around 30% higher than post-tax earning of Mr. A.
Will you still invest in Liquid Fund? Please have a look on below chart to understand post-tax earnings for 20% and 30% tax paying individuals for Liquid Fund and Arbitrage Fund.
Comparison of Post tax return generated from Liquid Fund and Arbitrage Fund
Who should invest?
Arbitrage mutual funds are mostly suitable for parking money for the short-term, say for the period of more than 1 month and above. Arbitrage Fund do not invest like other equity-oriented schemes, they do not take any directional bet on Equity market, they just lock the spread available between two prices at same point of time which we discussed in first part, and Arbitrage Funds are not for the long-term wealth creation.
Please remember about exit load in Arbitrage Funds which is ranging from 15 days to 2 months, so advice is please check exit load of Arbitrage Fund scheme before investing. Second the most important aspect is Arbitrage Funds are mildly fluctuating in the short run, even 1-month scheme return do not look attractive compared to Liquid Fund, ultra short-term or short-term income fund. Monthly returns of Arbitrage Funds are always volatile due to monthly expiry at different spreads.
We should look these funds as an alternative to liquid mutual fund, these funds are basically locking available spread, so return are purely dependent on arbitrage opportunity available at particular point of time. As said earlier these are not long-term wealth creation investment, so use it as a liquid investment and it should not be a major part of your portfolio.
Please remember Arbitrage Funds are mostly suitable for those investors who are in 20% or 30% tax bracket. If your investment horizon is less than 1 year, go with the Dividend option and investor who wish to stay invested for more than 1 year and less than 3 years should go with Growth option. An investor who is willing to invest for more than 3 years can look for growth plan of the Liquid Fund, FMP, Ultra short-term or short-term mutual fund.
Those investors who have short-term Capital gains in the same year from sources other than listed equity shares or equity-oriented mutual funds and those who can wait for 3 and further 6 months from their investment date can opt for Bonus option. However, recently AMFI release guidelines for AMC to check Bonus stripping practice. Even SEBI also raised the concern saying “bonus option is not legitimate, avoid bonus stripping plans to check tax evasion”. Many investors used bonus stripping as arbitrage of tax.
Points to remember
- Always calculate Post-tax return before selecting any investment schemes.
- If your investment time horizon is less than 3 months go with Liquid Funds, if it is more than 1 year but less than 3 years, choose Arbitrage Fund and if it is more than 3 years choose FMP, Short term, ultra short-term, or Liquid Fund.
- Arbitrage Funds are the suitable investment vehicle for those investors who fall in 20% and 30% tax bracket.
- Individual who are in 10% tax bracket, and wants to invest for less than 1 year should select Liquid Fund, but if investment time horizon is more than 1-year choose Arbitrage fund.
- For Arbitrage fund, Investment time horizon must be more than 3 months, to avoid short-term volatility due to a different spread of investment by the fund for a different time frame (monthly expiry at different spreads).
- Invest in Dividend option if your investment time horizon is less than a year and choose Growth plan if investment timeframe is more than 1 year to 3 years.
- Do not withdraw your investment from Arbitrage Funds other than the expiry date of F&O segment or immediate after the expiry date, remember the concept of arbitrage, the price of Cash and Future coinciding on expiry of the future contract.
- All funds do not follow a pure arbitrage strategy, please check scheme documents before investing. Go with pure arbitrage plan.
- Stay away from arbitrage plus plan, spot the difference between pure arbitrage and arbitrage plus plan.