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Combining Arbitrage and MIPs to Create Something New

Replacing fixed-income assets with equity arbitrage can result in a new type of tax-efficient hybrid fund

Once upon a time, a type of mutual fund called the Monthly Income Plan (MIP) used to be a great favourite among conservative investors who wanted slightly better returns than one could get in fixed income alone. The basic idea of such funds is that they are essentially conservative fixed income funds with a garnish of equity. That garnish could be 10 to 25 per cent, and its intent is to boost the returns of the fund to above what can be earned from a fixed-income fund alone. Essentially, such funds encapsulate the entire portfolio of a conservative investor who wants a little bit of equity returns in exchange for a little bit of equity risk. Over any period longer than three to five years, the equity risk becomes minimal.

The fly in this ointment is taxation. Long-term capital gains on equity fund investments if help for overvyear is zero. However, to qualify as an equity fund, at least 65 per cent of a fund's assets have to be invested in stocks. Clearly, MIPs don't qualify and are thus exposed to the same tax levels as non-equity funds. Now, after the recent budget, this tax load has become even more onerous.

In fact, the tax situation is quite adverse. Having a little bit of equity in what is mostly a fixed income fund means that equity returns are taxed as non-equity. This is actually quite ridiculous, since long-term investments in equity are practically the only kind of investments that are genuinely tax-free in India. To generate any equity gains and then get them taxed as non-equity gains sounds like the worst kind of tax inefficiency.

Nevertheless, in the traditional MIP fund, this is unavoidable. Interestingly, the recent adverse tax changes on non-equity mutual funds seems to have triggered some innovation in this area. One of these is the use of arbitrage between equities and their derivatives to run funds with the low risk and returns level of fixed-income investments but the tax treatment of equity. Such funds have been around for many years but have gained new attention in the new tax dispensation. And now, Kotak Mutual Fund has even launched an MIP-equivalent fund that uses equity-derivative arbitrage to offer investors the stability of an MIP with the favourable tax treatment of an equity fund.

How does this magic work? The idea is quite simple. The fund manager looks for opportunities where there is a price gap between a stock price and its futures price. For example, let's say the market price of a stock is Rs 100, and the price of its futures a month hence is Rs 101. Then, the fund manager could buy the stock and simultaneously sell the derivative. Effectively, this is a predictable and safe gain of one per cent over the month. However, it is an equity trade, and therefore a fund composed of such investments would get classified as an equity fund, and its investors would pay no long-term capital gains tax.

In principle, this kind of an investment does not have the safety level of the kind of investments that short-term debt mutual funds make, and definitely not of bank fixed deposits. However, in practice, they offer a much higher post-tax return in exchange for a small technical increase in risk. The MIP-equivalent arbitrage fund that Kotak Mutual Fund has launched is slated to dedicate 40-75 per cent of its assets to equity arbitrage, 10-35 per cent to debt investments and 10-25 per cent for normal (non-arbitrage) equity investments. To ensure tax efficiency, the fund will ensure that the total equity and equity derivative investments that it has stays within the prescribed limits.

While this is yet just one fund that has just been launched (and there's no guarantee on how well it will be run), this is a promising model for combining stability and tax efficiency with just the right amount of equity exposure for the conservative investor. For once, there's actually a worthwhile innovation in creating a new type of mutual fund.