Many of you might have invested in debt funds since they received favourable tax treatment. Those falling in the higher tax bracket had a chance of generating a higher post-tax return, as against that generated by Fixed Deposits (FDs).

But now that after budget 2014-15 as debt funds seem to have lost appeal, you may be thinking about shunning long-term investments in debt funds. The finance minister has increased the rate of long term capital gain tax from 10% to 20% (possibly with indexation) on transfer of units of other than equity oriented funds. Thus the rate of 10% without indexation is completely done away with. Likewise, the holding period for such purpose and for it to be classified as Long Term Capital Gain (LTCG) is also increased from 12 months to 36 months. You see, although this move is primarily aimed at removing the tax arbitrage which existed between FDs and Fixed Maturity Plans (FMPs) due to favourable tax treatment to latter; it has affected a number of retail investors of open-ended debt mutual funds.

Now that debt mutual funds have lost their appeal, it is perceived that arbitrage funds would be a close substitute to debt funds, especially to those who are looking to receive favourable tax treatment but yet earn returns comparable to those generated by debt funds. So is it really a substitute? Well, before analyse that let's first understand how does an arbitrage fund work.

What is an arbitrage fund?
Securities are traded in different markets and in different segments (such as cash and derivatives) of the capital market. For example, equities can be traded in cash as well as derivatives market. Cash market is a market where, normally, investors buy securities for taking delivery and settling the trade by paying for their purchase. While in case of derivatives market, especially in 'futures', where there is no immediate delivery of security is taken but the contract is entered to buy / sell security at some future date. On several occasions, same asset is traded at different prices in different segments and / or different markets, which results in an arbitrage. This arbitrage opportunity has given birth to arbitrage funds , wherein they try to capitalise on such opportunities by exploiting price differentials. They take opposite positions in different markets / different segments depending on opportunities in order to clock returns. They rarely result in a loss, but mind you a possibility of a loss cannot be ruled out.

Why have they come in limelight suddenly?
You see, arbitrage funds are classified as equity funds for the tax purpose. Meaning, short term capital gain is taxed at 15% and long term capital gains are exempt from tax. Moreover, for the purpose of calculation of LTCG, the period is over 12 months. This gives them advantage over debt funds, especially if you are investing in them for long-term.

But are returns comparable?
Those who want to switch from debt funds to arbitrage funds must be concerned about the return potential of arbitrage funds. If you are one among them, it may come to your surprise that arbitrage funds have outperformed long-term debt funds over shorter as well as longer time frames.
 

Arbitrage funds vs. long term debt funds...

	6 Months	1 Year	3 Years	5 Years	STDEV (Annualised)	Sharpe
Category Average of Arbitrage Funds	4.4	9.2	8.8	7.6	0.88	0.46
Category Average of Long Term Debt Funds	4.0	6.9	8.4	7.1	0.97	0.15
Crisil Composite Bond Fund Index	5.0	7.4	7.8	6.6	3.93	0.03
Crisil Liquid Fund Index	4.6	9.8	8.8	7.4	0.45	0.72

Data as on July 21, 2014
For the purpose of calculating category average, 13 arbitrage funds and 71 long term debt funds have been considered.
Returns over 1 year are compounded annualised
Standard Deviation and Sharpe Ratio are calculated over 3-Yr period assuming a risk-free rate of 7.38% p.a.)
(Source ACE MF, PersonalFN Research)  

As given in the table above, arbitrage funds as category have posted higher returns on an average basis than long term debt funds over the last few (1,3 and 5) years. Moreover, lower Standard Deviation and higher Sharpe Ratio indicate that arbitrage funds have fared better on a risk-adjusted basis than long term debt funds as well Crisil composite bond fund index. It is noteworthy that the performance of arbitrage funds is comparable more with that of Crisil liquid fund index.

PersonalFN is of the view that, although in past 5 years arbitrage funds have done better than long term debt funds; the primary reason for the same is long term debt funds have done badly. Interest rates were high so bonds were under pressure which has resulted in the underperformance of long term debt funds. If one considers, investing in arbitrage funds as an alternative to liquid funds, gains from arbitrage funds are subject to short term capital gain tax, if held for a period of less than 12 months.

PersonalFN believes arbitrage funds work too much for little extra returns. Success of Arbitrage Funds is contingent upon:
 

• Market volatility;
• Risk-free rate of return; and
• Ability of fund houses to get access to real time market data
   

Market volatility and risk-free returns are the factors that are beyond the control of the fund manager. Thus there is no guarantee that there will always be arbitrage opportunities available. This leaves small margin for errors. PersonalFN is of the view that, one may take exposure to arbitrage funds, but adopt caution and do not expect too much even though it is an equity oriented fund. They can no way be a substitute for investing in debt mutual funds.

PersonalFN believes before taking exposure you should assess your risk appetite and thereafter effectively and prudently allocate your investible surplus to generate optimum returns rather than chasing investments that appear attractive on their face value.

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