YOUR QUERIES: MUTUAL FUNDS: In volatile markets, look at arbitrage funds with a 3-6 month horizon

Remember, widening of the spread differential can lead to arbit-rage funds delivering negative returns for very short periods.

I have been investing in liquid funds for five years and now the returns are very low. Should I look at arbitrage funds in the hybrid category?

Suresh Mathur

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Liquid funds are typically used by investors to park their emergency corpus. The underlying investments are diversified across high (safer) credit quality instruments with minimal duration risk. Since 2019, the RBI has cut the policy rate sharply (250 bps) and announced a slew of measures to support the slowdown in the economy. The measures announced along with abund-ant liquidity in the banking system resulted in yields falling across the yield curve, particularly at the shorter end. As a result, liquid funds have delivered low returns over the past year.

Arbitrage schemes are hybrid funds, which take arbitrage positions in equity and related instruments for at least 65% of the portfolio, and park the remaining corpus in mostly high-quality fixed-income instruments and cash & equivalents. These funds capture the price differential between the spot and futures markets. The spread differential reflects the rates in the money-market rates and consequently the performance of arbitrage funds is generally close to that of liquid funds. The spread differ-ential rises in times of high volatility in the equity markets, presenting an oppor-tunity for fresh investments to capitalise on the higher rates (relative to money market rates) prevalent in the markets.

Arbitrage funds score over liquid funds owing to their favourable taxation, which yield higher post-tax returns for the same level of pre-tax returns. For holding periods of up to 1 year, the short-term capital gains are taxed at 15% (excluding cess and surcharge, if applicable), as compared to the 30% tax rate for liquid (and other debt funds) for investors in the highest tax bracket.

For holding period of 1-3 years, gains in arbitrage funds are taxed at 10% (only excess gains above Rs 1 lakh are taxed), compared to 30% for the highest tax bracket investor. Investors with a horizon of at least 3-6 months can look to enter such funds, particularly during volatile periods. Arbitrage funds have an exit load of 1-6 months. Remember, widening of the spread differential can lead to arbit-rage funds delivering negative returns for very short periods. Also, assess fixed-income portion of such funds in respect of underlying credit and duration risk.

The writer is director, Investment Advisory, Morningstar Investment Adviser (India). Send your queries to

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