Arbitrage funds can be a better alternative to FMPs

After the taxation of fixed maturity plans was changed by Arun Jaitley in his maiden Budget last year, fund houses have seen investors withdrawing their money from FMPs. Some have opted for arbitrage funds that work out to be a good alternative as they are tax efficient if an investor stays with them for a year.

Until the change in taxation, FMPs worked out to be more tax efficient if held for 13 months as they came with indexation benefit, which resulted in lower tax outgo. Now, the gains are taxed at 20% if held for over three years. Else, the returns are clubbed with the income and the person needs to pay tax as per the applicable income tax slab.

Though the data on the amount of money that has flowed into the arbitrage funds since the Budget announcement is not available, fund houses agreed that the category has seen sustained inflows in the past few months.

But does it make sense for investors to shift their FMP allocation to arbitrage fund? Experts say it depends on the investment horizon. “Arbitrage funds are classified as equity investments. This means, if a person remains with the fund for over a year, there will be no long term capital tax gains on it,” says Vetri Subramaniam, chief investment officer at Religare Invesco Asset Management Company. While FMPs have a lock-in, these investors can exit arbitrage funds whenever they wish paying the exit load if they withdraw before a year.

Harsha Upadhyaya, chief investment officer – equities at Kotak Mahindra Asset Management, explains how these funds work. Arbitrage funds take advantage of the price difference between the stock price in the cash market and in the derivates segment. For example, if a stock is trading at Rs 100 in the cash market and at Rs 101 in the futures, the fund managers take advantage of this discrepancy. “While these schemes invest in equities they don’t carry the risk of stock market fluctuations, as their returns are not altered by the market movement.”

They are best suited for conservative investors looking at moderate returns from market in a tax efficient way. Historically, these funds have had returns between eight and 10%. If you are looking for an investment horizon of one – two year, arbitrage funds work out to be better option than a debt fund due to tax efficiency. For shorter term investors should look at debt funds. Arbitrage funds don’t give step-by-step returns like, say a liquid fund. Their returns vary every month depending on the opportunities available in the derivates segment.

Subramaniam of Religare point out that before investing in these funds, investors should ensure that the fund is a pure play arbitrage fund. Over time, fund houses have introduced variations of these funds. Today there are arbitrage funds also invest part of their corpus in stocks and the remaining is used for arbitrage opportunities. “This can add to the average returns but also carry risk of lowering them if the markets are not doing well.”