Leveraging equity taxation with arbitrage funds

When it comes to safely parking lumpsums in mutual funds, debt funds are the preferred choice for most investors because of the predictable returns.

But debt funds have a bad reputation when it comes to the taxation angle. All debt funds are deemed short-term capital assets and so the capital gains on sale of debt fund units are taxed at slab rates. Indexation benefit also is not available. This could mean a tax rate of 30 per cent (before surcharge and cess) for individuals falling in the highest tax bracket. Enter arbitrage funds: arbitrage funds seek to provide debt-like returns with equity taxation.

What are arbitrage funds?

Arbitrage funds aim to take advantage of the price difference (arbitrage) between the cash market and the derivatives market. Fund houses do this by buying (long position) a certain amount of a security (say shares) in the cash market and simultaneously selling (short position) the same amount of that security in the derivatives market (say futures market) where the price is higher. Now what this does is create a perfect hedge for the long position in the cash market and hence, protects against price volatility, while also making money off the arbitrage.

Typically, the portfolio of an arbitrage fund will have listed equity shares north of 70 per cent of net assets and an equal percentage of exposure to derivatives due to the hedging. Since equity instruments constitute more than 65 per cent of the net assets, such funds qualify for taxation applicable for equity-oriented funds. Commercial papers, certificates of deposit, cash and units of liquid funds make for the rest of the portfolio.

How do arbitrage funds work?

Here’s a simplified illustration. Let’s assume TCS futures expiring after one month are trading at ₹4,300 and the stock is available for ₹4,280 in the cash market. There is an arbitrage of ₹20 here. On identifying such an arbitrage opportunity, the fund house will simultaneously initiate a short position in TCS futures at the strike price of ₹4,300 and buy (long position) shares of TCS at ₹4,280 in the cash market. On the expiry date, both the long and short positions will be squared off at the spot price of TCS as cash market and futures market prices tend to converge. The difference, a gain of ₹20 is guaranteed on expiry, irrespective of the spot price. Here’s how.

Let’s say on expiry day, the spot price is ₹4,400. The long position on squaring off will yield a gain of ₹120 (₹4,400–₹4,280). But the futures will make a loss of ₹100 (₹4,300–₹4,400). The gain on a net basis will be ₹20 (ignoring brokerage, STT and other costs). Let’s take a case where the spot price is lower than the buy price of the long position, say ₹4,200. In this case also, the net gain will be ₹20 (long position loss of ₹80 + short position gain of ₹100). Thus, the fund house stands to make fixed gain irrespective of volatility in the share prices. This ‘fixed’ gain acts as an accrual income to the portfolio, somewhat similar to interest payouts from bonds.

Returns and taxation

Arbitrage funds are benchmarked against the Nifty 50 Arbitrage Index. Historical performance of the benchmark and a few large funds in the category are given in the accompanying table. As seen there, the index has delivered returns close to the CRISIL Liquid Debt A-I Index, which serves as a benchmark for liquid funds. The arbitrage funds in the table have beaten both their own benchmark and CRISIL Liquid Debt A-I Index.

Arbitrage funds get the same treatment as equity-oriented funds for tax purposes. For a unit of arbitrage fund to qualify as a long-term capital asset, it needs to be held for more than 12 months. If so, the tax rate is 12.5 per cent, for gains exceeding ₹1,25,000. A short-term capital gain tax of 20 per cent applies for a unit sold within 12 months.

On a post-tax basis, while the CRISIL Liquid Debt A-I Index would have given a return of 5.1 per cent (7.3 per cent x (1-0.3)) after 1 year (assuming 30 per cent tax slab), the Nifty 50 Arbitrage Index would have returned 6.7 per cent (7.7 per cent x (1-0.125)).