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You can Invest in arbitrage funds for Tax Benefits
The increase in AUM is one of the reasons for the recent fall in returns.
From a tax-planning perspective, arbitrage funds offer the best of both worlds: the risk profile of such funds is comparable to debt products, but they are taxed as equity funds. While dividends and long term capital gains (if held for one year or more) will be tax-free in the hands of investors, short-term capital gains is applicable if you hold it for less than one year and will be taxed at a lower rate of 15%.
However, the sudden fall in returns of arbitrage funds has disappointed many investors. On an average, the category generated simple annualised returns of 6.88% for the monthly futures and option (F&O) cycle ended August, and 6.62% for the F&O cycle ended September 2014.
This recent development has prompted investors to compare arbitrage funds with tax-free bonds that are available at 7.3-7.4% in the secondary market. But, does this make arbitrage funds a bad choice? Well, not quite. The change in tax rules for non-equity funds in Budget 2014 saw investors migrating from debt funds to arbitrage funds and, therefore, collections zoomed during the last two months to see the assets under management (AUM) for arbitrage funds to almost double. Since more money is chasing the limited arbitrage opportunity in the market, these funds have witnessed a fall in returns.
New money is coming to arbitrage funds in a gradual manner, so parking that has not created any problem. The sudden jump in AUM in July was primarily due to collection of over `5,000 crore by one of the fund houses, allegedly because of the "bonus-stripping structure" offered by them to high networth individuals (HNIs). "A major part of this bonus-stripping money may move out after three months, once the bonus is declared. So, the industry-wide AUM may remain constant in the coming months.
There are other reasons for the fall in returns of arbitrage funds. There has been an overall decline in the arbitrage opportunity in the market with the India Vix hitting an all-time low in August. Trading activities shifting from large-cap companies, which are part of the F&O segment, to mid-cap companies outside the F&O segment, is yet another reason for the fall in arbitrage opportunity. This explains why the total value of stock futures is not moving up with the market indices in the last few months. The stock market getting into a correction mode is another reason for the fall in the arbitrage opportunity. The arbitrage spread will be more when the market is bullish and the spread comes off when the market cools.
So, should investors hold on to arbitrage funds? Yes, say experts. This is because the fall in volatility is temporary and the returns from arbitrage funds should improve when volatility spikes once again. Returns from arbitrage funds will never have a steady pattern like that of liquid funds. There will be some months of low returns and some months of high returns.. This is also not the first time that the returns of arbitrage funds have come down to these levels. The category average return had fallen to 6.28% in November 2013. The arbitrage opportunity has also started picking up and is expected to generate better re turns for the category. After falling into the 6-6.5% range in the last two months, things have started improving. The September to October rollover has happened between 7.5% and 8%, net of expenses Therefore, investors who are already invested in arbitrage funds should hold on to their positions. Since returns from the arbitrage opportunity vary from settlement cycle to cycle, investors need to come in with a reasonably long term view, ideally a one year holding period, to make the capital gains tax-free.
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