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Home >Money >Personal Finance >Despite low returns, arbitrage mutual funds may make sense for some investors

The calendar year 2020 was not good for arbitrage funds. Most of them recorded their worst monthly performance in May 2020, where they saw negative returns. The one-year category returns—average returns of all arbitrage funds—too, fell to 3.6% as of 1 January 2021, according to data from Value Research. In the past three and five years, these funds had an annualized return of 5.1% and 5.6%, respectively.

Arbitrage funds are suggested my many investment advisers as a replacement for liquid schemes for investors in the higher tax brackets. As arbitrage funds are classified as equity funds, they are tax-efficient for those in the higher tax brackets—20% or more.

Should investors stay away from them due to their recent performance? “They may still make sense for some investors depending on their tax bracket and investment horizon. However, at this point, debt funds that invest in short duration papers could do better," said Malhar Majumder, partner, Positive Vibes Consulting and Advisory, a firm that distributes financial products.

We tell you why returns from arbitrage funds are low and should you invest.

LOW RETURNS

Arbitrage funds aim to capture the price difference between the spot and the futures market. Spot market, also known as the cash market, is where securities are traded for immediate delivery, while in the futures market, participants buy and sell commodity and futures contracts for delivery on a specified future date. Such opportunities are higher when the markets are volatile as it can lead to a wider price difference (or spread) between the cash and futures market.

“At times, this spread can turn negative—when the futures market is at a discount to the spot. Typically, it happens when the market sentiments are bearish," said Kaustubh Belapurkar, director, fund research, Morningstar India Advisor, a platform that offers mutual fund research and investment management services. In April and May, the market sentiment was negative due to covid-19.

SHOULD YOU INVEST?

If you are in the highest tax bracket, in specific circumstances, it may still make sense to invest in arbitrage funds. Their one-year returns are on a par with that of liquid mutual funds.

“In the past calendar year, the arbitrage funds category has given an average return of 4.2% and liquid funds category returns are 4%. The post-tax returns of arbitrage funds would be better than liquid funds for those in higher tax brackets," said Belapurkar. The returns from arbitrage funds are excluding Essel Arbitrage Fund, which gave 0.94% and Value Research data shows that its corpus is zero.

If you are investing in an arbitrage fund, keep a minimum six-month horizon, and don’t worry about some periods of negative returns.

“Investors should not worry about short periods of negative returns. The way the product is structured, they don’t give negative returns if you hold them for over six months," said Majumder.

If you redeem your investments in an arbitrage fund for up to one year, the profits will be taxed as short-term capital gains (STCG). The tax treatment of arbitrage funds is the same as any other equity fund. You will pay a tax of 15% on STCG.

In the case of liquid funds (or debt schemes), profits are taxed as STCG for up to three years. If you withdraw before three years, your gains are clubbed with your income, and tax is payable at the marginal rate.

If you are in the 20% or 30% tax bracket, and if returns from liquid and arbitrage funds are the same, your post-tax returns would be higher in the arbitrage funds if you withdraw within three years of investing.

If you redeem after one year, there is no tax for profits up to 1 lakh. Any gains over that are taxed at 10%.

In certain market conditions, arbitrage opportunities are limited. If you ride it out, you can still make better post-tax returns in arbitrage funds over short-term debt funds.

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