Category: Investment Management

The Arbitrage Edge

The Arbitrage Edge- Tax efficient and return efficient!

The term arbitrage refers to buying and selling of an asset in order to profit from the difference in prices between two markets. For example, the equity stock price of Infosys was Rs. 1,243 in the cash market and the futures price of Infosys was Rs. 1,252 in the futures and options market. Hence by buying the stock in cash market and selling or shorting Infosys futures in the futures market you would be making a profit of Rs. 9 (Rs. 1,252- Rs. 1,243).

Similarly, arbitrage funds are a type of equity funds which primarily take advantage of the price differences of the same asset (equity) between cash and derivatives market. Though they are termed as equity funds, they do have a provision of investing a small part of their portfolio in debt markets i.e., around 20% to 30% is invested in debt and the remaining 70% to 80% is invested in equity.

Arbitrage funds are most suitable for people who are looking for:-

  • Safe returns
  • Tax efficiency
  • Best alternative to fixed deposits for a period of 1 year.

These funds work best during high market fluctuations andthey are mainly aimed at giving you returns within short period of time, so it does not technically qualify for long term investment but more acceptable for parking short term money.

Why invest in Arbitrage for the short term, do they score over liquid funds and FMPs?

For a long time liquid funds and fixed maturity plans (FMPs) were a better alternative for fixed deposits for a holding period of one year. But, in 2014 budget, the tax provision on all debt funds was changed. You can enjoy the indexation benefit for debt mutual funds only after 3 years. This is when Arbitrage funds hit the spotlight as a better alternative for fixed deposits. Since, arbitrage funds are categorized as equity funds, like all equity funds, capital gains and dividends are tax free after one year making them superior to liquid funds and FMPs as well.

There are cases where, some arbitrage funds do not directly invest in equity after making profits through price differences; instead, the balance is invested in debt market. These types of funds are usually called as arbitrage plus plans. For example, IDFC arbitrage plus fund, ICICI prudential blended plan etc invest the balance amount in actively managed debt funds to the extent of more than 60%. Also, some funds increase allocation in debt market if they do not find good opportunities in equity markets. But, once these funds increase exposure in debt market more than 35%, the fund will be treated as a debt fund and taxed accordingly.

For an arbitrage fund to be treated as an equity fund, the equity debt allocation should be 65%:35%; only then the returns after 1 year will be tax free in arbitrage funds.

The below comparison chart and table depicts the difference between post tax returns of fixed deposits, FMPs, liquid funds, and arbitrage equityfunds:-

Fund name Post tax Returns
Edelweiss Arbitrage Fund 7.0%
SBI liquid fund 5.7%
SBI 1 year FMP 6.0%
SBI 1 year FD 5.8%

In the table and graph, liquid funds, FMPs are taxed at 30% since debt funds are taxed at marginal rates if the holding period is less than 3 years and fixed deposits are taxed at marginal rates irrespective of the holding period.

However, arbitrage funds are completely tax free after a year making it supreme for short term parking of money.

Ashok Eshwaran

Head Research and Client Relations

Dilzer Consultants Pvt Ltd

7 Sep 2016