Can we use tax-free gains from arbitrage MFs for short-term needs?

Published: October 19, 2020 at 11:24 am

Last Updated on October 19, 2020 at 11:24 am

Arbitrage mutual funds invest a predominant part of their portfolio in derivative and arbitrage instruments associated with the stock and bond markets. Aside from unnatural events (see below), their day to day volatility is similar to ultra-short-term funds. Thus typically arbitrage funds have debt fund-like NAV fluctuations and equity-fund like taxation. This makes it appealing for investors in all tax slabs due to their tax-free gains.

The reason being the total realised gain from equity fund units that are older than 365 days is tax-free up to Rs. 1 lakh. Gains above Rs. 1 lakh are subject to 10% tax + cess. Unless your money requirement is huge, or you make multiple redemptions from equity MFs, many short-term requirements can be met in a tax-free manner with arbitrage MFs. Even if one has to pay tax, it would be lower than debt funds or fixed deposits. However, there are risks to be considered.

Before we begin, if this is a new fund category for you, you can use this article to understand how they work: How Arbitrage Mutual Funds Work: A simple introduction. If you are looking for detailed examples of their tax-benefits see: Generating tax-free income from arbitrage mutual funds?

The primary risk is credit defaults. Thanks to SEBI, arbitrage mutual funds have become hybrid funds with the need to only invest 65% in equity and equity-related instruments. The AMC could invest 35% in risky bonds and get hit by a credit default.  Example: Principal Arbitrage Fund. A small portion of their portfolios can have direct equity exposure. This is not something to lose sleep over though.

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As per Sep 2020 factsheets, ICICI Equity Arbitrage Fund alone hold AA+ bonds ( 0.54% of Bharati Telecom and 1.1% of HDFC Bank), The bond quality of all other holdings and of all other funds is above this. For the time being, the mutual fund industry is treading cautiously but this can quickly change.

The second important risk, as we just saw – Arbitrage mutual fund returns reduce due to negative spreads – depend on the demand and supply in the derivatives market. If this drops, the returns drop. For example, these are the monthly returns of the Nifty 50 Arbitrage index.

April 2020 0.3%
May-2020 0.14%
Jun-2020 -0.33%
Jul-2020 -0.34%
Aug-2020 0.35%
Sep-2020 0.33%

Also see: Why arbitrage funds become more volatile when market uncertainty increases. So if you invest in these funds for durations of just a few months, then you should expect some losses. These monthly losses will manifest as lower quarterly returns and lower annual returns. So do not go in expecting too much even if you buy and hold for long. See: How much return can I expect from Arbitrage mutual funds?

Can we use arbitrage funds for the short-term? It depends on your outlook and risk appreciation (as with any decision!). A small portfolio of your emergency fund can reside in arbitrage funds but if you lose sleep over negative monthy returns over a few months then you should not.

We are currently at the start of a rising interest rate cycle with inflation looming large. Going forward a money market mutual fund (which balanced credit risk and reward well) can/may provide better returns over the short term than arbitrage funds. If you invest in arbitrage funds today, compare returns after a while and start regretting, these are not for you.

Arbitrage funds can be used to reduce tax outgo by those who appreciate risks and the futility of regret. Those who prefer market risks only for long term goals are better off with FDs and RDs but must pay the price with “as per slab” returns.

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