View: Fall in inflation index makes arbitrage funds attractive

Despite their exotic sounding name, arbitrage funds are quasi fixed income in nature.

By R Balachandran

The word arbitrage for long-time market watchers usually evokes memories of Ivan Boesky, the legendary «arb» trader of Wall Street, who made a fortune by arbitraging stocks in play for an acquisition. His apparent prescience in stock picking turned out to be a sordid case of insider information, and he ultimately paid the price.

He was sentenced to three years in jail on insider trading charges. His close associate and Wall Street financier Michael Milken, the «junk bond king» from the firm Drexel Burnham Lambert, met a similar fate.

Arbitrage explained

Arbitrage seeks to exploit price differences of an asset across different markets by simultaneous buying and selling of the asset. As the trade picks up momentum and more arbitrageurs rush in to make money on such inefficiencies, the window of arbitrage disappears. In a M&A arbitrage, the arbitrageur buys the stock of the company being acquired while selling the stock of the acquirer.

Arbitrage funds in the Indian mutual fund industry are more mundane in nature. Fund managers buy a particular stock in the cash market and simultaneously sell it in the futures market, when it commands a price which is higher than that in the cash market. The differential should ideally be the risk free interest rate for this tenor, with volatility providing the alpha factor.

The return on arbitrage funds closely tracks the trends in short term interest rates. The position is fully hedged, hence the market risk on account of any adverse price movement of the underlying stock is eliminated.

Today, almost every fund house offers arbitrage schemes with the larger funds each having assets under management (AUM) of more than Rs 4,000 crore. Returns which were in the range of 8 per cent in the past are now hovering around 66.5 per cent.

Asset allocation

Despite relentless selling by FIIs in Indian stocks, retail investors through the red hot SIP product have managed to keep the market buoyant. Most pundits have refrained from calling out a bubble formation in Indian stocks.

On the contrary, the cheer leaders are in full cry. Asset allocation discipline therefore is all the more required in today’s markets with a reasonable case for arbitrage funds being part of the mix in addition to traditional debt mutual funds.

Sharp fall in CII

Debt mutual funds require a three year lock-in to qualify for long-term capital gains benefit; post this period, the capital gains is taxable at 20 per cent after indexing the cost of acquisition based on the Cost Inflation Index (CII) notified by the government annually.

With the dramatic fall in consumer price inflation, the year-on-year rate of increase in CII too is seeing a sharp fall. CII which was 10 per cent in 2013-14 over the previous year has plummeted to 3 per cent for 2017-18. The consequent negative impact on post-tax debt mutual fund returns has not received much attention.

With most of the capital gains on account of fall in interest rates already captured in the NAV, current investments in relatively conservative short-term debt funds can fetch around 7 per cent. Of this, inflation indexation benefit is 3 per cent as of now, hence investors need to pay 20 per cent tax on the rest, bringing down their overall post-tax return to around 6.2 per cent. The days of tax-free returns on fixed maturity plans and debt funds are over for now.

Despite their exotic sounding name, arbitrage funds are quasi fixed income in nature. But they offer a unique advantage over debt funds as their tax treatment is on par with equity funds.

The short-term capital gains if redeemed within one year is taxed at 15 per cent, while debt funds redeemed up to 3 years attract tax at the marginal rate which is 30.9 per cent for individual taxpayers in the highest bracket.

Although the current post-tax return of conservative short-term debt funds is comparable to arbitrage funds, the latter offer a clear advantage as the tax-free status kicks in just after one year, while long-term capital gains benefit for debt funds requires a minimum holding period of three years. With credit rating downgrades and defaults in investments throwing a regular scare on debt mutual funds, arbitrage funds offer a relatively safer option.

The biggest enemy of arbitrage funds is their own popularity. As more funds chase limited arbitrage opportunities, the yield could trend down further. Tax treatment too could change. But for now, their tax efficient nature, and a reasonable yield over today’s inflation rate make these funds a must have, in an investor’s asset allocation strategy.

(The author is an expert in credit risk and fixed income investing.)

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