With interest rates going up in the economy due to rise in inflation and tightening liquidity by central banks, Fixed deposits as an investment avenue are set to gain traction again. While the interest rates on home loans have been increased almost immediately, the interest rate on fixed deposits have also started to go up as competition gears up for the same money. Top rated NBFCs like HDFC and Bajaj Finance of the world have increased the rate of interest on fixed deposits already.
However, due to the continuous rally in the equity markets, people are still more inclined towards stock markets. Another reason for not investing in a fixed deposit is the taxation impact on interest. However, investors need to understand that fixed income instruments are also an important part of investing and provide much needed asset allocation & diversification to the portfolio. We have been posting various articles on alternatives for fixed deposits.
We did an article on Peer-to-Peer lending as an alternate investment tool. In this post, we are going to discuss a category of mutual funds that stands to offer better post tax returns than fixed deposits and lower volatility than an equity oriented scheme.
Arbitrage funds are hybrid mutual fund schemes that aim to generate returns for the investors by taking advantage of price differences of the same underlying assets in different market segments. These funds can also invest in debt and money market instruments. As per SEBI’s directive, arbitrage Funds must invest at least 65% of their assets in equity and equity related securities (e.g. stock futures, index futures etc.).
Arbitrage process involves simultaneous buying and selling the same stock in different market segments to make risk free profits. If the price of a stock is different in different markets, you can make risk free profits by buying the stock in the market where price is lower and simultaneously selling it in the market where price is higher. One of the popular strategies of arbitrage is buying in the cash market and selling in the future market & then reversing the trade on the day of expiry.
Let's try to understand this with an example:
Stock price of TCS in the cash market is Rs. 3,000 & in futures market is Rs. 3,050. A fund manager can sell the stock in the futures market and buy it in the cash market and wait till the expiry. Let us see how the outcome works.
TCS stock closes at Rs. 2,950 on the expiry day: Fund will have a loss of Rs. 50 in cash market & profit of Rs. 100 in futures market. Hence the net profit will be Rs. 50.
TCS stock closes at Rs. 3,100 on the expiry day: Fund will have a profit of Rs. 100 in cash market & loss of Rs. 50 in futures market. Hence the net profit will be Rs. 50.
TCS stock closes at Rs. 3,000 on the expiry day: Fund will have no profit & no loss in cash market but a profit of Rs. 50 in futures market. Hence net profit will be Rs. 50.
This ensues that no matter where the market goes, an arbitrage fund will book a profit on the difference between both prices at the expiry.
Tax treatment on arbitrage funds: Being a fund with minimum 65% exposure to equity oriented instruments, the gains are taxed as equity oriented mutual funds in following manner:
Short-term capital gains: If you redeem your investments within 1 year, then the gains will be taxed as short term capital gains at a tax rate of 15%
Long-term capital gains: If you redeem your investments after 1 year, then the gains will be taxed as long term capital gains at a tax rate of 10%. However, there is an exemption of Rs. 1,00,000 per annum on long term capital gains from equity oriented mutual funds. Hence the tax rate of 10% will apply on gains above Rs. 1,00,000
Ideal investment horizon: Since entire equity exposure has to be fully hedged, these schemes are suitable for an investment horizon of more than 3 months. However, investors should note that in order to get the benefit of long-term capital gains exemption, the holding period has to be a minimum of one year.
Who should consider investing in arbitrage funds?
- Investors with an objective of park short term funds instead of keeping them in savings account.
- Investors who fall under higher tax slab and are looking to generate better post tax returns with easy liquidity.
- Investors with short term goals of 3 months or more.
Tip: Arbitrage funds operate like a fixed income fund where there is no equity exposure, an investor should check for the expense ratio charged by the fund. A higher expense ratio will lead to lower returns & hence investors should avoid a fund if it is charging a very high expense for management. One can always approach an advisor to check if a particular scheme is suitable for his risk appetite before taking a call on whether to invest or not.
CA Rohit J. Gyanchandani is Managing Director, Nandi Nivesh Private Limited, A Pune based Wealth Management Company.