Keep in mind that widening the spread differential can lead to arbitrage funds offering negative returns for very short periods of time.

I have been investing in liquid funds for five years and now the returns are very low. Should I look at arbitrage funds in the hybrid category?

Suresh Mathur

Liquid funds are generally used by investors to park their emergency corpus. The underlying investments are diversified into high credit quality (safer) instruments with minimal duration risk. Since 2019, the RBI has sharply lowered the key rate (250bp) and announced a series of measures to support the slowdown in the economy. The measures announced as well as the abundance of liquidity in the banking system caused yields to fall across the entire yield curve, especially at the shorter end. As a result, liquid funds have generated low returns over the past year.

Arbitrage systems are hybrid funds, which take arbitrage positions in equities and related instruments for at least 65% of the portfolio, and place the remainder of the corpus in fixed income instruments and primarily high cash and cash equivalents. quality. These funds capture the price differential between the spot and futures markets. The spread differential reflects the rates of money market rates and therefore the performance of arbitrage funds is generally close to that of liquid funds. The spread differential increases during times of high volatility in the stock markets, providing an opportunity for new investments to capitalize on the higher rates (relative to money market rates) that prevail in the markets.

Arbitrage funds score higher than liquid funds because of their favorable taxation, which produces higher after-tax returns for the same level of pre-tax returns. For holding periods of up to 1 year, short-term capital gains are taxed at 15% (excluding tax and surcharge, if applicable), compared to the 30% tax rate for cash (and other debt funds) for investors in the highest tax bracket.

For a holding period of 1 to 3 years, gains in arbitrage funds are taxed at 10% (only excess gains greater than 1 lakh of Rs are taxed), against 30% for the investor of the tranche d. highest tax. Investors with a horizon of at least 3 to 6 months may seek to enter these funds, especially in times of volatility. Arbitrage funds have an exit charge of 1 to 6 months. Keep in mind that widening the spread differential can lead to arbitrage funds offering negative returns for very short periods of time. Also weigh the fixed income portion of these funds against the underlying credit and duration risk.

The author is Director, Investment Advisory, Morningstar Investment Adviser (India). Send your questions to [email protected]

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