Why Are Arbitrage Mutual Funds Profitable?

Arbitrage Mutual Funds

Arbitrage mutual funds, considered an option for short-term investment options such as liquid and ultra-short-term funds, attract investors’ late attention.

According to data from the Association of Mutual Funds in India, Asset Management (AUM) assets under arbitrage funds increased by nearly 22% to Rs 63,310 crore on 26 July and 52,062 crores by 31 March 2019.

The increase can be attributed to the latest cases of credit downgrades and defaults that have an impact on sentiment towards some debt mutual funds, including liquid funds.

Arbitrage MFs try to capitalize on the price differential between two markets of the same asset (stock or index), such as cash and futures. As a result, the risk in these funds is comparatively small, comparable to liquid assets. 

Keep changing the structure of taxes

The budget was implemented in 2014–15, extending the period from 12 months to 34 months in debt funds to qualify for long-term capital gains (LTCG) tax, with liquid funds being less attractive. On the other hand, taxation in equity funds remained unchanged and they continued to enjoy tax exemption on LTCG (if shares were sold after 12 months) and dividends were declared.

As the arbitration funds are treated as equity funds for taxation reasons, after 2014, investors switched to these funds to park their short-term cash. Investors are looking for earnings from time to time also park in their cash arbitrage dividend plans.

However, the implementation of the 10% tax on LTCG and the dividend announced by the Equity Funds in the Budget 2018-19 turned many investors away from arbitration funds. After March 2018, there was a massive outflow in such funds dividend plans.

However, recent examples of default of some debt funds suggest that investors once again had to turn to arbitrage funds. 

Yields are unstable

The returns produced by arbitrage funds depend on the volatility of the equity market and the prevailing short-term rates of the monetary market. 

Tax benefits

Tax efficiency is what makes arbitrage funds a better alternative to liquid and other short-term debt funds. Arbitrage funds are quite favorable for investors searching for a parking space ranging from six months to a year for their cash in the 20 percent or 30 percent tax bracket. Some of the best performing funds are Reliance Arbitrage, DSP Arbitrage, IDFC Arbitrage and ICICI Pru Equity-Arbitrage.

However, in the short term, arbitration funds can produce adverse yields. Over the previous five years, our back-of-the-envelope calculation based on their NAVs demonstrates these funds produced unfavorable returns over a holding period of up to 45 days.

The arbitration scheme was earlier considered an equity scheme for tax. This means that they previously enjoyed a zero tax on long-term capital gains. This tax savings made him a favorite of mutual fund investors, For a brief period, especially those with significant park volumes. Long-term capital gains of more than Rs 1 lakh in a financial year are reintroduced after LTCG tax with 10 percent tax.

 

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