Arbitrage funds’ spreads are attractive, and investors must take advantage

livemint.com:

The prevalent discussions and debates in the mutual fund space have been about mid- and small-cap valuations, loss of tax advantage for debt funds, SIP (systematic investment plan) mobilizations, new folios and the like. Apart from these, a development happening in recent times is that in the equity market, the spread between the cash or spot segment and the stock futures segment has widened. In a volatile non-trended market, this spread tends to move up. This essentially being the cost of carrying a trade till the expiry of the futures contract, in a non-trended market, the uncertainty pushes it up.

The mutual fund category that benefits from cash-futures spread is arbitrage funds. A majority of 65% or more of the portfolio of arbitrage funds is invested in this. The balance 35% of the portfolio is invested in debt or money market instruments. For fund categorization purposes and tax purposes, arbitrage funds are equity funds. However, there is no directional call on equities, implying that returns from arbitrage funds do not depend on equity stock prices going up. The spread on the day of taking a portfolio position in cash market, and contra position in stock futures market, is locked in, one month at a time.

The advantage of arbitrage funds, from the investors’ perspective, is taxation. In the growth option of the fund, for a holding period of less than one year, tax rate on the returns is 15% plus surcharge and cess. If you hold it for more than one year, the tax rate is even lower, 10% plus surcharge and cess. The differential in net-of-tax returns with debt funds has become even more pronounced since the indexation benefit has been taken away from debt funds.

Let us take an illustration. Let us say, returns from