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Arbitrage Funds Disappoint

Decreasing arbitrage opportunities and a likely change in taxation in the coming budget may badly hit these funds

Many investors are wondering whether it is time to say good-bye to arbitrage funds, as they ponder over their lacklusture performance and the likely change in their tax treatment in the coming budget.

As widely expected, the performance of these schemes have started suffering lately. They have been underperforming other debt schemes in the last six months. Arbitrage funds have offered 4.14 per cent in the last six months, compared 4.22 per cent by liquid funds, 5.65 per cent by short term funds and 8.33 per cent by income funds during the same period.

Many investment experts have been apprehensive that huge inflows into these schemes are likely to dry up arbitrage opportunities available in the market and it will adversely impact the performance of these schemes. Arbitrage schemes look to exploit the difference in price between the cash and the future market.

There is also speculation that the coming budget will take away the tax advantage of these schemes. Currently, these schemes qualify for long term capital gains tax for investments held in them over a year as they are treated as equity schemes for the purpose of taxation. The budget may classify them as debt schemes for the purpose of taxation, fear mutual fund industry players.

"My advice is not to react to a speculation in the market. At the moment, the budget proposal is just a speculation, so don't act on that. As for the performance of these schemes are considered, it is likely that the arbitrage opportunities may come down in future and it may reduce the returns," says Suresh Sadagopan, Principal Planner, Ladder 7 Financial Advisories, a wealth management firm. "I believe these funds may still give 6-8 per cent returns in future, which is quite good if you consider the tax advantage they have now."

Arbitrage funds became the most sought after investment for many debt investors after the interim budget in July. The finance minister hiked long term capital gains tax on non-equity investments to 20% from 10%, and also increased the lock-in period to qualify for long-term capital gains to three years from one year. This has resulted in many debt mutual fund investors shifting their investments to arbitrage funds for better tax-adjusted returns.