Can You Think Of A Risk-Free AND Tax-Free Mutual Fund?

Question 2: Name mutual fund types with near zero probability of money-loss?

I am big fan of lowering risk and tax. Before I save and invest I try to choose instruments with minimum risk and tax out-go. Of course the type of risk differs: loss-of-money-risk when saving and loss-of-value-risk (or inflation risk) when investing. Choosing instruments for investing (for long-term goals) is much easier than choosing instruments for saving (for short term goals), simply because there are more options for saving. A typical everyday example is choice of debt funds: most investors are confused about which debt fund to choose when.

When I first started learning about debt funds, I asked myself a variant of the above mentioned question: Identify a class of debt fund which has near zero probability of money loss. That is, it has never given negative returns, over, say, any one-year period since inception of the fund.

The answer: liquid funds.  Why is this important? To me (a self-proclaimed contended investor) managing risk is more important than returns. I cannot stomach any kind of risk for short term goals. For long term goals I have forced myself to accept the volatility in returns is necessary to offset loss of value risk. So I invest 60% of what I can invest each month in equity. Rest is in debt instruments. I can stomach some amount of volatility in debt instrument returns for long term goals. I simply cannot stomach any volatility in returns for short term goals. So even if a goal is 2-3 years away I prefer to choose only a liquid fund.

For such durations ‘experts’ would recommend a short-term fund or an income fund. However these funds have lost money and therefore can lose money. So no thank you I will stick to liquid funds (btw, not all rear view mirror driving is harmful). Experts cannot see past returns most of the time. One of many reasons why we should do our own research: first on our temperament and then on products.

However this is not about me or about liquid funds. This is about answering question 2. Or more specifically, is there any fund, besides a liquid fund, with near-zero probability of money-loss. The answer and the topic of this post (finally!): Arbitrage Mutual Funds

To understand how arbitrage mutual funds operate we must understand what an arbitrate opportunity is. Took me a while to get this until I put it together in the form of an example: Pondicherry is a favourite destination of those who love a drink or four! Due to difference in duties and other taxes, alcohol is much cheaper there than in neighbouring Chennai (and of course whole of TamilNadu). So if I buy crates of alcohol in Pondicherry (at MRP), find a cheap means of transport, and sell it in Chennai (at MRP) I will make a profit equal to the difference between the Chennai price and Pondicherry price. Of course the profit will be diminished by the transportation cost.

Ignoring legal aspects, this price difference is known as an arbitrate opportunity. There are two key points to note:

  • The profit is small as I gain only from the price difference
  • The profit is Risk-free. Tomorrow if the union govt decides to make alcohol prizes uniform the arbitrate opportunity is lost. However I lose no money (I can simply stop the business before the law is enforced).

 Do arbitrate opportunities have zero risk? Theoretically yes. In practice my consignment can get destroyed in transport. My usual customers may turn teetotallers etc. So risk under unusual circumstances cannot be ruled out.

How do mutual funds which exploit arbitrate opportunities work? Firstly it is important to know that many, many types of arbitrate opportunities exist which these mutual funds can exploit. I half-understand only one. So I am no expert. The following is not wrong but lacks a quite a bit of finesse you would associate with an expert.

A stock can be traded in (at least) two ways: (1) you buy/sell for what it is worth today in the so called cash market. (2) You enter into a contract and agree to buy/sell it in future at a price agreed upon today. This is knows a futures contract or simply futures. An arbitrate opportunity arises when the cash market price of a stock is different from the futures market price. Reasons for this difference are not yet clear to me. All I know is that it is related to efficiency of information transfer in the stock market which is not perfect.

If the futures market stock price is lower than the cash market price, I buy stocks from the futures market and sell in the cash market. Soon people will become aware of this price difference (partly because of my action!) and the price will be same after a few days or earlier. Before the prices equalize I make a profit equal to the stock price difference (transaction costs will have to be accounted for). More importantly the profit is risk free. When the prices equalize I will look for a different arbitrage opportunity.

Like mentioned before arbitrage opportunities are subject to risk when the market crashes. This risk is of course different from the everyday market risk which equity funds are subject to. That said many Indian Arbitrage funds (ones I checked) survived the 2008 crash with no dip in NAV.

Here is the icing on the cake:  Arbitrage mutual funds are taxed like equity mutual funds. Gains realised by holding units for more than a year are tax free. So they are the answer to the titular question: Arbitrage mutual funds are risk-free AND tax-free instruments.

Returns: Typically returns of arbitrage funds are similar to those of liquid funds and ultra-short term funds, that is about 6-8%. Arbitrage opportunities abound in turbulent markets and they have done quite well in recent times. Returns should not be a factor for choosing them though.

Potential Uses of Arbitrage Mutual Funds: The tax-free and risk-free nature of such funds can be exploited in many ways:

  • They are ideal candidates for short-term goals where capital protection and minimum tax-outgo are more important than returns. Since losses can arise under unusual circumstances it is best to use it for non-crucial short-term goals (a year or more away).
  • They are decent candidates for parking a portion of your emergency fund. A SB account and liquid funds are ideal candidates in terms of liquidity. A small portion can be kept in arbitrage funds so that we can let it grow without worrying about tax. Note: Redemption can take about 10 days or so.
  • When we have a home loan going it is best to set aside about 3 months EMI as part of the emergency fund. This part alone can be put in an arbitrage fund since liquidity is typically not crucial.

I am thinking out loud on the following. Feel free to disagree and correct me if I am wrong:

  • If gold can form 10% of a diversified portfolio why can’t arbitrage be a small part of it? It certainly has all the necessary qualities. It performs well in a turbulent market and gives steady (but low returns).
  • Can it be used for tactical asset allocation?  One way of reducing risk in a portfolio is to completely exit equities when the index surges higher and higher with a correspondingly high P/E ratio and re-enter at a low enough P/E ratio. At least some part of the portfolio can be shifted to arbitrate funds to minimize tax. Of course if a crash hits there could be some loss while holding the arbitrage fund. However it should still be lower than that associated with a typical equity fund.
  • When a long term goals nears its dead line the equity component must be shifted to debt. While this makes the corpus safe the corpus now becomes subject to tax. Perhaps at least a portion can be shifted to arbitrage funds to minimize tax and risk? Perhaps even a STP (equity to arbitrage) can be set up towards the end of the investment tenure?

Can you think of anymore uses for these funds?

Resources:

Disclosure: I use UTI Spread Arbitrage Growth – Direct Option.

Postscript: UTI also stands for urinary tract infection. So if you type 'UTI Spread' in a search engine the first few hits will not be about mutual funds 🙂

Update: I have changed 'financial instrument' in the title to 'mutual fund'. This seems to be confusing. I received PPF and tax-free bonds as answers to the rhetorical question!

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33 thoughts on “Can You Think Of A Risk-Free AND Tax-Free Mutual Fund?

  1. ashalanshu

    Dear Pattu, thanks for posting a good article as usual. One more use can be for retired people. Instead of putting money in debt funds for shorter durations like 1-2 years or even for regular monthly income. Keep amount in these Arb. funds & after 1Y holding start redeeming tax free pension.

    Thanks

    Ashal

    Reply
  2. sunder

    pattu, i think the best risk free and tax free investment instrument is equity, equity equtiy. the only condition is that one needs to ensure that at any point of time one has adequate money in debt instruments that would take care of one's needs for the next five to six years: yes, equity can go down, but it cant remain down for long. it has to go up sooner than later. another condition is that when one invests in equity including equity mfs, one should have a proper undersanding of the fundamentals of the companies one is investing in case of direct equity and a clear understanding of the nature of the funds and the team managing them in the case of mfs. consequently, one should have a regular watch on developments relating to the cos/ funds. its that difficult: we have value research and morning star to help us.

    Reply
    1. pattu

      Trouble is a sideways market can kill a goal. From 1991 to 2001, Sensex returns were negative. One should be an extraordinary stock picker to have survived this (FT Bluechip did quite well). For someone retiring in 2001 this would have terribly impacted returns unless he/she had started in the 1980s
      Sideways markets can persist for many many years.A diversified portfolio and at least annual monitoring is crucial.

      Reply
      1. karthik.

        When you say sensex returns where negative it is the index that you are talking about.A good actively managed mutual fund would have given higher than 10% return even during this time?

        Reply
  3. sunil

    Dear Pattu,

    One thing missed is they are not as liquid as "Liquid Funds", and have a small portion charged if sold before a particular period (179 days for UTI).
    I however, want to bring them to your notice...
    One thing wanted to clarify, are the returns mentioned in VRO for a period > 1 Year are a CAGR???
    Thanks,
    Sunil Ramidi.

    Reply
    1. pattu

      Dear Sunil, I am aware of this. I was focusing on the tax-free aspect of arbitrage funds. Hence chose not to mention it.

      Yes all returns over 1 year listed in VRO (and any other decent website) are CAGR returns.

      Reply
      1. sunil

        Dear Pattu,

        Thanks for the prompt reply.

        I should thank you for writing this article at the moment i am exploring areas to invest so that my TAX outgo is minimum (i fall in 20% tax bracket).

        I am going through the articles given by you for reference. I shall fall back to you if i have any doubts.

        For me, i shall study first then invest.

        Thanks once again.
        Sunil.

        Reply
  4. sunil

    Dear Pattu,

    However, CRISIL cautioned, due diligence before selecting an arbitrage fund is important. “Investors need to differentiate between pure arbitrage and arbitrage plus funds. In the former, the equity component is completely hedged while the latter can take unhedged positions and carry a higher risk. Only eight of the 15 domestic arbitrage funds can be considered as pure arbitrage funds”, it said.

    This was given in an article (You shared) by Business Line. Which are those with Pure Arbitrage???

    Thanks,
    Sunil

    Reply
    1. pattu

      Good point. i think we will have to look at individual fund objectives and portfolios. I think HDFC Arbitrage Fund is not a pure one. Reg. others I am not sure. Will need to dig a little more.

      Reply
      1. sunil

        Dear Pattu Sir,

        Any success in finding those Funds which are of Pure Arbitrage?.

        Thanks in Advance,
        Sunil.

        Reply
        1. pattu

          If you look at the list of the arbitrage funds in VRO or MC you could see some funds have the 'plus' in the name. Trouble is we cannot assume the ones that simply say 'arbitrage' alone is a pure one!
          May I know what your investment horizon wrt these funds?

          Reply
  5. sunil

    Dear Pattu sir,
    Exactly, that's the issue.
    My Investment horizon is 2 years.
    UTI Spread is a Pure Arbitrage Fund - I have just gone through the Scheme Doc for UTI.
    Rest, i haven't seen sir.
    Thanks in Advance,
    Sunil Ramidi.

    Reply
    1. pattu

      That is good to know. Over a two year period I think thew risk associated with even a arbitrage plus fund should be pretty small. Thanks

      Reply
  6. Aditya

    Sir, I want to create an emergency fund of mine. Sb account gets exhausted. After reading this article I have decided to start a sip of rs. 1000 in arbitrage fund of uti(the same you mentioned) and sip of rs. 1000 in liquid fund. Can you please suggest good liquid fund where I can plan to invest. And one more thing, did I get your article in right spirit with my mentioned plan of saving (investment)?

    Reply
    1. pattu

      You have got the spirit of the article right. You should
      note that NAV of an arbitrage fund will not increase each day by small
      amounts like a liquid fund.

      Suppose the market fails for two days and increases the third day, the
      A-fund will lose a little money that day.

      However risk of loosing money over one year is very small.

      You can use quantum liquid fund.

      Do not start SIPs in liquid as well as A-fund. Simply get a login account
      and buy whatever you can each month.

      SIP is unnecessary paperwork.

      Do keep visiting the blog and sharing your views on the articles and
      calculators.

      Reply
  7. Pushkar

    Just for info. Quantum MF allows SIPS from online login.
    They send u SIP amount as bill in net banking and u just pay it by due date.
    No paper work at all.

    Reply
    1. pattu

      Yes I aware of that Pushkar. I am an investor too. I am only against stating SIPs if the investor is disciplined.

      Reply
    1. pattu

      Arbitrage funds are more tax efficient although long term returns will be similar to debt funds. Of course the risk in liquid funds is typically lower.

      Reply
  8. charu

    Pattu Sir, Very nice explanation about A-funds. Thanks for the same. You seem to have touched every topic for the MF investors. You rock!

    Reply
  9. Deepa

    Hi...you read my mind...almost and I was pleasantly surprised to stumble upon your post and get answers to most of my questions. The comments have made me wiser too. Continuing the discussion regarding disciplined investing and SIPs, can I also make lump sum investments in Arbitrage funds?... when I receive a lump sum maturity amount of an insurance policy for instance

    Reply
  10. shashi

    when liquidity and volatility make their way back into the stock markets (which is looking more and more likely by the day)...arbitrage funds will also take a hit ... when underlying assets become illliquid arbitrage is a gone case.... so to term them risk free is dangerous..... use caution

    Reply
  11. Nithin

    Dear Pattu,

    1. Under "Arbitrage Funds: Do they work too hard for too little?" link that you have given, after reading this article I see that it is trying to say that arbitrage funds are riskier and even risk adjusted returns are lesser. See: "There is no comparison between" in the article to get to the lines to what I am referring. This article had opposite views to your article as well as the other links that you have given. I think you were referring to pure arbitrage whereas this article was talking about arbitrage funds collectively.(Both Pure and Plus).What say ?

    2. Is there any specific way/website that differentiates between pure arbitrage and arbitrage plus funds ? (i.e., Filtering pure arbitrage funds from the rest)

    3. I got to know that there are only 8 pure arbitrage funds. To shortlist one among these, can we use the same methods that are used to shortlist liquid & Ultra Short debt funds ?
    Is there any other important parameter ?

    4. You have considered "UTI Spread Arbitrage Growth – Direct Option". When I went through VRO, I observed that there are many other funds with better returns, lesser risk, from equally reputed fund houses. So why this fund ? Just curious...

    Moreover, this fund is in the bottom two in the list for Sharpe ratio,Sortino ratio & alpha and in the top two for beta. (Contradicting criteria for good fund selection). Is it anything to do with portfolio manager ?

    Note: I compared regular version of all funds.

    Thanks in advance.

    Reply
  12. Ashish

    Hi,

    I agree with author but would like to consider one more opportunity of practically 0 risk and no tax (Actually there's tax but very less). The author did mention and acknowledged that, but the article did not explore it.

    First, this is for the class of investors who don't need to hold investment for long term (like greater than 8 for equity). But someone who wants to park money for 3-4 or 5 years. This strategy works only if you hold more than 3 years.

    As the article mentioned , its Liquid or ultra liquid Funds. They invest only in securities maturing in 90 days or less, so there's practically 0 risk. Even if you hold the mf for 5 years, on the backend the funds manager will keep on investing and redeeming in 90 days security. the returns more in lines with fixed deposit. Most of the liquid/ultra liquid have given 8-9% return.
    The trick is to sell after 3years which qualifies it as LCTG. You can chose the the 20% taxation after indexation, which will literally bring your effective gain to 1% and you pay 20% tax on tax, which is very minuscle.
    E.g. Suppose I put 30lac in a an ultra liquid fund in 2010 and assume 9% CAGR. Its current value after 5 years will be roughly 30lac*(1.09^5)=46.15 lac.

    Cost after 5 years considering indexation (CII as per GOV figures) = 30lac*1081/711 = 45.61
    Tax you have to pay =20% of (46.15 - 45.61 lac)= 10,800 🙂

    I am actually waiting to time the market, so sitting now on cash and waiting for next major correction. But don't want to lose interest and liquidity , so have adopted this strategy.
    Incase I need all cash to invest before 3 years, then I will lose the advantage and it will be the equivalent of FD with normal tax paid as per yearly accrual.

    The author is right and now I am considering arbitrage fund now. But I still have the feeling that its risky as compared to liquid funds. I just want as much security as a FD. At any point of time, the liquid funds are holding 90 days of security, so really there's nothing that can happen. Unless interest rates are reduced throughout the market by RBI, in which case any alternative fixed income investment will also suffer.

    The monthly NAV of liquid/ultra liquid MF literally rises close to (8-9)/12%. So its actually safe to take out anypoint of time.

    Now I am confused with regard to arbitrage fund. It does have a serious advantage of 1 year to avoid paying instead of 3 years. But still I somehow feel jittery, because at the end of day its investing in equity market (even though its some algorithm spotting spotting this arbitrage and doing trading in milliseconds). My whole intention is to take opportunity of next major Market correction, and I don't need my money subjected to this market volatility. What would the author suggest for my situation?

    Reply
  13. Jayadeep Purushothaman

    If you have a question about DIY investing, the answer is usually here 🙂 Thanks Pattu for this article, I was in fact thinking of ways to invest liquid cash which at the moment is just SB account. Thanks again!

    Reply

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