Low-risk arbitrage funds have attracted significant inflows in April and May as investors found them attractive due to tax benefits as well as a safe-haven during market volatility.
In April, these funds saw inflows of Rs 11,790.37 crore and they improved further to hit a record high in May at Rs 15,701.97 crore, according to data from the Association of Mutual Funds in India (Amfi). As of May-end, the category had net assets under management of Rs 2.34 lakh crore, data shows.
Experts believe that high inflows can reduce the spread of returns, but it remains a good option for HNIs and high-tax-bracket investors to park their money for the short term.
This is because despite the lower risk involved, they are taxed as equity funds: short-term gains at 15-20% and long-term gains above Rs 1 lakh at just 12.5%, compared to liquid/debt funds taxed at the full slab rate up to 30%.
Nikhil Rungta, CIO, LIC Mutual Fund, said that while the tax efficiency of arbitrage funds is a benefit, the real trigger has been investor caution amid heightened market volatility. “Arbitrage strategies tend to thrive in such environments as they exploit mispricing opportunities that are more frequent compared to a one-way trending market,” he explained.
According to him, the current phase of volatility — driven by earnings season and global macro uncertainties — is keeping cash-futures spreads attractive, which is essential for generating returns in arbitrage funds. He added that elevated derivative turnover and rising open interest across sectors are creating a broader pool of opportunities for arbitrage strategies to work effectively.
Arun Kumar, VP & head of research at FundsIndia.com added that the last 6 months’ returns of arbitrage schemes are similar to that of liquid funds which had led outflow from the debt schemes in May with Rs 40,205 crore of outflow.
He said at this juncture investing in fixed income should be done through income plus an arbitrage fund of funds. “Almost all popular fund houses have launched such schemes, if they have not launched, they are planning to launch one,” he said.
Devang Shah, head – fixed income, Axis Mutual Fund said, this blend aims to provide the stability associated with debt investments while leveraging the opportunities presented by arbitrage strategies.
According to the Finance (No. 2) Act 2024, if an Income plus Arbitrage FoF allocates between 35% and 65% of its portfolio to arbitrage funds (which are treated as equity for taxation purposes), it falls under the “Non-Specified Mutual Fund” category, he said.
Industry players were expecting a change in the taxation of such schemes, as for a scheme to be under equity taxation rule, 65% of the assets in equity related schemes but arbitrage funds do not directly invest in equities and look to generate returns from arbitrage opportunities between the cash and derivative markets.
For investors holding units of such funds for at least two years, the gains are taxed at a lower rate of 12.5% (plus applicable surcharge and cess) after indexation benefits. This can be notably more favourable compared to the taxation of traditional debt mutual funds, where gains are taxed as short-term capital gains, as per the investor’s income tax slab, irrespective of period of holding.