Arbitrage Funds
The most popular product that is sold on the premise of tax breaks in this country is insurance. Arbitrage funds probably comes next, especially in the wake of demonetization. As these funds are gaining momentum, let us examine what it offers!
Definition
Arbitrage Funds (AF) is a type of mutual fund that leverages the price differential in the cash and derivatives market to generate returns. The returns are dependent on the volatility of the asset.
In simpler terms, this fund mimics a stock trader with his position covered. It buys stocks in the equity market and simultaneously sells it in the derivatives market. The price differential between equity market & derivatives market is used to generate returns for the fund.
Performance
Arbitrage Funds perform very well in bull markets, when volatility is high and money market yields are low - present times. And they do not perform in stagnant/bear markets and when money market yields are high (2010-2013).
Although the performance of AFs are benchmarked against liquid funds, these two categories of funds are fundamentally very different. So, only peer-to-peer comparison of AFs is meaningful.
Why the popularity?
As 65% of the holdings is in equity & its derivatives, it is treated at par with equity funds and hence are tax free if held for 12 months. Many funds in this category were launched in 2014 when the bull market in sensex just began, which is a ripe plarform for AFs to perform.
It was also in the same year that the holding period for FMPs (Fixed Maturity Plans) to qualify as long term was revised from 12 to 36 months. This led investors to search for tax free avenues with a maximum of 12 month holding period, resulting in a shift from debt to equity oriented Arbitrage funds.
Who is it suited to?
It seems to be designed for businesses to park their idle cash and enjoy tax-free returns in a short time (1 year). It is also suitable to stock traders familiar with derivatives. Inflows into AFs have particularly spiked post-demonetization. And its story sells well with a retail investor who is obsessed with tax savings.
Planner's Take
Fundamentally, there are three issues with AFs.
Definition
Arbitrage Funds (AF) is a type of mutual fund that leverages the price differential in the cash and derivatives market to generate returns. The returns are dependent on the volatility of the asset.
In simpler terms, this fund mimics a stock trader with his position covered. It buys stocks in the equity market and simultaneously sells it in the derivatives market. The price differential between equity market & derivatives market is used to generate returns for the fund.
Performance
Arbitrage Funds perform very well in bull markets, when volatility is high and money market yields are low - present times. And they do not perform in stagnant/bear markets and when money market yields are high (2010-2013).
Although the performance of AFs are benchmarked against liquid funds, these two categories of funds are fundamentally very different. So, only peer-to-peer comparison of AFs is meaningful.
Why the popularity?
As 65% of the holdings is in equity & its derivatives, it is treated at par with equity funds and hence are tax free if held for 12 months. Many funds in this category were launched in 2014 when the bull market in sensex just began, which is a ripe plarform for AFs to perform.
It was also in the same year that the holding period for FMPs (Fixed Maturity Plans) to qualify as long term was revised from 12 to 36 months. This led investors to search for tax free avenues with a maximum of 12 month holding period, resulting in a shift from debt to equity oriented Arbitrage funds.
Who is it suited to?
It seems to be designed for businesses to park their idle cash and enjoy tax-free returns in a short time (1 year). It is also suitable to stock traders familiar with derivatives. Inflows into AFs have particularly spiked post-demonetization. And its story sells well with a retail investor who is obsessed with tax savings.
Planner's Take
Fundamentally, there are three issues with AFs.
- From a risk profile perspective, under the premise of tax savings, this fund shifts an investor from low risk to high risk (debt to equity).
- From a product perspective, if an investor is ready to take on equities, alternatives are available in large-cap & multi-cap equity funds.
- From arbitrage perspective, when more money chases fewer arbitrage opportunities, returns will be zilch.
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