Arbitrage Funds

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Due to rising assets under management, the returns from arbitrage funds are likely to fall further

Investor interest in arbitrage funds has seen a spike since the long-term holding period for debt funds was increased from one to three years. Since arbitrage funds are treated as equity funds, their holding period for long-term capital gain is one year. Long-term capital gain from equity is tax-free (short-term capital gain is taxed at a concessional rate of 15%). Equally importantly, the dividend income from equity does not attract dividend distribution tax.

Since arbitrage funds make money from low-risk buy and-sell opportunities available in the cash and futures market, their risk profile is similar to that of a debt fund. In fact, most arbitrage funds use Crisil Liquid Fund Index as their benchmark. So, arbitrage funds bring to the table the best of both the equity and the debt world.That's not the whole picture though.

Even as arbitrage funds offer several benefits, their net impact seems to be all but negated on account of falling returns of these funds. The category average one year rolling returns for arbitrage funds have come down drastically from 8.07% a year back to just 6.38% now. This 6.38% return is significantly lower than the historical return of 7.74% and 8.78% generated by competing products such as liquid funds and ultra short-term debt funds respectively. The historical post-tax returns across tax slabs (see bar graph) show that arbitrage funds have been of some use to only investors in the highest tax brackets.

So, why are returns of arbitrage funds falling? Though the recent stock market sluggishness -- there are more arbitrage opportunities in a buoyant market--is one reason, a sudden spike in inflows to arbitrage funds is primarily responsible for this.

The ability to generate returns comes down when more money chases the same arbitrage opportunities. The assets under management (AUM) of arbitrage funds continue to bulge: The collective AUM of arbitrage funds jumped `5,403 crore in one month, taking the total AUM of arbitrage funds to `31,669 crore in August.

If such inflows continue to arbitrage funds, their return profile will come down. Investors need to make a realistic assessment of the value of arbitrage funds to their portfolio. There's no need to rush in.

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