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Arbitrage Or Short-Term Debt Funds For Your Short Term Money?

Arbitrage Fund returns have fallen in the past three years. From delivering 9-9.5% per annum not too long ago, they (as a category) delivered just 6.43% in the previous twelve months. Short Term Debt Fund returns, on the other hand, are on the rise - with a category average of 9.43% in the past year, which is very impressive for a low-risk instrument

Have some money to put away for a few months? You're probably confused about whether to opt for short-term debt funds or arbitrage funds - both low risk mutual funds intended for the purpose of helping investors deploy their short-term capital. Let's try to understand which one will work best for you.

First and foremost, it's important to understand that both funds work entirely differently, although they do possess similar risk profiles. Arbitrage Funds work on the principle of taking hedged positions in equities and capitalising on mispricing between a stock and its futures price. By executing the risk-free trade of buying the stock in the spot market and simultaneously selling a same quantity of it in the futures market when the futures price is higher than the spot price, fund managers lock in a riskless profit because both prices will necessarily converge on or before the expiry date. Short-term debt funds, on the other hand, earn returns by buying bonds that are due to mature in 12-24 months, thereby accruing their coupons and also benefitting from any capital gains that may accrue on these bonds.

Arbitrage Fund returns have fallen in the past three years. From delivering 9-9.5% per annum not too long ago, they (as a category) delivered just 6.43% in the previous twelve months. Short Term Debt Fund returns, on the other hand, are on the rise - with a category average of 9.43% in the past year, which is very impressive for a low-risk instrument.

The reason behind this trend is the fact that when the holding period for flagging returns from debt funds as long term were raised to three years (from one) in 2014, a lot of investor money that was earmarked for a ~1-year time horizon flowed out of debt funds into arbitrage funds. As inflows into these funds rose, the arbitrage opportunities themselves narrowed - collapsing returns.

Going forward, too, one may expect roughly 6.5% per annum from Arbitrage funds. Short Term Debt Fund returns may temper down though, with yields falling in recent times. These funds may now struggle to deliver high yields without taking on unacceptable degrees of credit risk. We're likely to see returns in the range of 8% per annum from Short Term Debt Funds, which is still a higher expectation than Arbitrage Fund returns. Which one should you go for?

The answer to that question really lies in the difference in the tax treatment on the returns earned from both. While Arbitrage Funds returns are taxed as equity (15% on profits booked before a year, NIL after a year), returns from Short Term Debt Fund are clubbed with your income for that Financial Year - and hence taxed at your marginal income tax rate.

If you're in the highest tax bracket, your tax adjusted annualised return from Short Term Debt Funds will likely work out to 5.5%. If you're in the 20% or 10% brackets respectively, the real returns would be closer to 6.4% and 7.2%, respectively. In the event that you're retired and without any source of income, any profits that you book under Rs. 2.5 lakhs in a Financial Year would actually not be taxed at all - so your real return would be equal to the debt fund return, at close to 8%.

To sum up the above stated: the real returns from your Short-Term Debt Fund investment are likely to range from 5.6% to 8% annualized, depending upon your tax bracket. In comparison, Arbitrage Fund returns are likely to be closer to 5.5% before a year regardless of your tax bracket, and 6.5% per annum for any holding period exceeding one year, as your returns will be tax free in this scenario.

This table can serve as a useful ready reckoner for you to decide between the two:


As it turns out, Short Term Debt Funds score over Arbitrage Funds in most scenarios - despite their poorer tax efficiency. If you're in the highest tax bracket and plan to hold the moneys for a time frame between 1 and 3 years, the higher tax efficiency of Arbitrage Funds is likely to compensate for their lower returns, and result in incremental growth of around 100 bps per annum.


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Arbitrage funds Short-Term Debt Funds mutual funds


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