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Arbitrage Funds: Risk-Free and Tax-Free

Budget 2014's unexpected beneficiary, arbitrage funds could prove to be a good alternative to debt funds

This year's budget announcements have an unexpected beneficiary - arbitrage funds. With the budget completely blunting the tax advantage of debt funds compared to deposits or bonds, investors will have to hold their bond fund for three years for their returns to be treated as long-term capital gains.

For these investors, arbitrage funds could prove to be a good alternative considering that their returns are comparable to liquid funds while their taxation is similar to equity funds.

How do they work: Arbitrage funds invest in stocks and futures and earn their returns through differential pricing between a stock and its futures. They are able to generate returns through this difference in pricing without taking a call on market or stock price moves. Such arbitrage opportunities allow these funds to give returns similar to that of a liquid fund and yet enjoy the tax benefits of an equity investment.

But investors looking to take this route should note that this may turn out to be a short term opportunity. They may not continue to remain as attractive as they seem today if the government removes this tax arbitrage too. They may also lose this advantage if the government does not allow them to be classified as equity investments. If the arbitrage funds raise large assets, arbitrage opportunities may dry up as too much money chases these gaps. Arbitrage by its nature is self cannibalizing.

Arbitrage funds were first kicked off in 2004 and managed limited assets in the initial years. After almost drying up in 2008, they again started attracting modest assets recently. As on June 30, 2014, arbitrage funds had assets under management worth ₹5567 crores. Interestingly, just two funds - IDFC Arbitrage Fund - Regular Plan and Kotak Equity Arbitrage Fund account for more than half of these assets.

This could turn out to be a limited period offer for the fixed income investors to avail fixed returns by paying no taxes for the long term and lesser tax for the short-term. Avail the benefit till the offer lasts!!