Tax-free returns at a ‘zero’ Risk

After change in the tax treatment of debt funds, the investors are chasing better tax-efficient returns at zero risk and have found an opportunity in the arbitrage funds. These are one type of mutual funds that leverages the price differential in the cash and the derivatives markets to generate returns. The returns are mostly dependent on the volatility of the asset

Since the announcement of changes in the tax treatment of debt mutual funds by the finance minister, there has been a frenetic activity to find an alternative tax-efficient investment with similar risk exposure.

As per the new changes, the government increased the long-term capital gains tax on debt-oriented mutual funds from 10 per cent to 20 per cent, while the definition of 'long term' for debt mutual funds has been changed to 36 months from 12 months effective from July 10.

Short-term capital gains on debt funds are added to one's income and taxed as per the individual's income tax slab. This, at one shot, killed the advantage the debt Mutual Fund enjoyed over the bank’s Fixed Deposits (FD) making them at par.

Now, investors are chasing for better tax efficient returns at near-zero risk and have suddenly poured into the arbitrage funds. These funds are one 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.

Simply put arbitrage funds, as the name suggests, exploit the difference in the price of a stock between cash and derivatives markets or even between different stock exchanges such as BSE and NSE.

This strategy of buying and selling, similar and equal securities simultaneously from different markets/instruments help not just in only hedging the risk but profits from the mispricing between the markets. The profit would be the difference between the prices of the instrument in different markets.

For example, the price of a stock quotes at Rs 100 in the cash market and Rs 102 in the futures market. The fund invests in cash market and simultaneously executes a sell in futures market to lock in a profit of Rs 2 per share.

In volatile markets, the fund manages to capitalise on differences in prices of a stock between the equity market and the future market and thus reducing the risk in equities by hedging those using derivatives. These funds also deploy surplus cash in debt securities and money market instruments.

Arbitrage funds provide investors a safe avenue to park their money while grab on the market inefficiencies to generate profits for the investors, especially in high and persistent volatile markets. As these funds invest predominantly in equities, their tax treatment is at par with equity funds.

This is where the world of difference makes to the investor. This means, the long-term capital gains i.e. of holding units for more than a year attract zero per cent taxation over the gains. This would hence and beat all the debt (liquid/money market/FD) returns on the post-taxation while retaining a similar risk profile.

The returns from these funds are not too high but the risk to return is very attractive. The arbitrage nature of the transactions in these funds provides returns of liquid funds and yet enjoys the tax benefits.

So, a risk-averse investor trying to beat the FD/Debt MF returns, looking for consistent and dependable wealth creation could invest in these funds with a horizon of at least one year to take advantage of the existing tax laws. Though, the party would soon finish if they’re moved out of their current classification of equity funds.