It's a fund category that doesn't give you nasty periods of negative returns. It's a category that gives you fairly stable and steady returns that compare well against deposits, against liquid funds and against short term bond funds. And the returns are taxed on par with equity fund returns, which means no DDT on dividend distribution, 15% tax on short term capital gains and NIL on long term capital gains. Which means that your post tax returns are actually much better than alternative avenues for the same level of pre-tax returns. With so much going for arbitrage funds, why then is industry AuM of arbitrage funds only at around 4800 crores? For an industry that has crossed Rs. 10 lakh crores in AuM, that's a piffling 0.5% of assets in a highly tax-efficient, stable return product. What's wrong with arbitrage funds? What's keeping investors away from this fund category?
Check out what this data shows
It is said that a picture tells a story better than a 1000 words. In our staid world of money management, we substitute pictures with data tables, to narrate our stories better. Here is a data table put together by the team at Edelweiss AMC, which I think tells the story rather effectively.
Lets first understand the data before analyzing it. The Arb portfolio is a composite of 5 arbitrage funds - ICICI Prudential, Kotak, SBI, IDFC and JM. The periods chosen are not even, but represent bullish and bearish phases in the market over the last 7 years. This can be seen from the Nifty returns of each of these periods - as can be seen, Nifty returns keep alternating between positive and negative for each period, signifying bullish and bearish phases. For each of these bullish and bearish periods, Team Edelweiss AMC has collated Nifty returns and compared it with returns from the composite of 5 arbitrage funds and two indices that represent Liquid Funds and Short Term Bond Funds. The last two columns showcase volatility of Nifty and the composite of 5 arbitrage funds. All returns data shown here are absolute returns over respective periods and not annualized returns.
Arbitrage funds outperform liquid and short term bond categories
Total returns from arbitrage funds over the last 7 years, at 80%, are almost at the level of equity returns which returned 87% over the same period. This comparison however may not be relevant from a forward looking perspective as the last 7 years included only one big bullish year followed by extended periods of flat markets. All of us hope that the years ahead will be far better for equity markets than the last 5. Equity funds, I suppose, can be safely assumed to beat arbitrage funds in the next few years.
The interesting part however is a comparison of arbitrage funds versus liquid and short term bond categories, both of which see substantial investor interest, driven by stability of returns and tax efficiency. In both bullish and bearish market phases, arbitrage funds' returns compare quite well against the liquid index and the short term bond index. And, as mentioned earlier, the better tax treatment makes the post tax returns a lot more attractive, even when pre-tax returns are the same.
Flows always track returns - but not in this case
If there's one thing that is consistent about our industry, it is that flows always track returns. Any product category that generates superior returns, does get rewarded with incremental flows, in the hope of emulating recent performance. That's true across categories - equity, debt and gold. Why then do arbitrage funds not get their place under the sun, even after delivering competitive post tax returns across market cycles? What's wrong with this product category? To get a perspective on this, I turned to Mr.Bond - Sunil Jhaveri of MSJ Capital. Here's what Mr. Bond has to say :
Mr. Bond's favourite
"One asset class which stands out for its regular dividend paying capability, tax efficiency and safety of principal is arbitrage schemes. If redeemed on last Thursday of every month when F&O settlement takes place, it cannot generate negative returns; thereby safeguarding your principal. Also, since this asset class buys 80% plus of spot equity and sells the same in futures, it is treated as equity scheme for tax purposes with no applicable DDT and short term gains tax at 15% plus and zero long term capital gains tax.
During bearish periods of equity markets (when arbitrage opportunities are scarce), even if these schemes generate say liquid fund kind of returns, they are still better off by almost 28-30% due to no deduction of DDT. Hence, they can be said to have generated at least 30% higher returns than liquid schemes.
This has been one of my favourite asset classes since they were launched way back in 2004-05 with 50:50% (50% arbitrage and 50% money market instruments, which were therefore treated as debt schemes in those days) and then converted to 80:20% variants (80% arbitrage and 20% money market instruments). I have included these in core portfolios for some of our clients wishing to earn better tax efficient regular cash flows.
This asset class thrives on equity markets doing well as well as volatility (which enhances overall returns)."
Some points for us to consider
If arbitrage funds score well against liquid funds and short term bond funds, are we not doing enough justice to them because they sound too complicated to explain to clients? Or is it because we are wondering how to position them in client portfolios? Here are some thoughts on how we can perhaps position them :
As financial planners, we always recommend a contingency reserve to be maintained for unforeseen circumstances. This is usually put into liquid funds, as they are regarded as the safest. This money usually stays put for long periods of time, even several years. And, through this period, the client continues suffering DDT on the dividends that are declared daily and faithfully reinvested. Is there an opportunity for us to think a little smarter and allocate this contingency reserve money to arbitrage funds? If the money stays for more than a year, returns become tax free when redeemed - and the chances of a contingency reserve staying for more than a year is reasonable good in most cases. Arbitrage funds may not be suitable for very short term needs, because returns are optimized when redeemed during settlement of the F&O cycle. However, as the holding period gets stretched from 1 month to 6 months and beyond, the date of redemption starts impacting returns to a far lower extent. As with the case of contingency reserve, for any other surpluses that you think are likely to remain for 6 months and more, arbitrage funds could be a useful alternative to consider. HNI equity portfolios often have an allocation to arbitrage, pending investment into identified stocks at target prices. Is there an opportunity for us to move that into arbitrage funds instead of arbitrage transactions, and get better tax efficiency?
There are, I am sure, many more angles to explore in positioning arbitrage funds in investor portfolios. Why then are we not doing enough justice to this product category?
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