Despite low returns, arbitrage mutual funds may make sense for some investors


The 2020 calendar year has not been good for hedge funds. Most of them recorded their worst monthly performance in May 2020, where they recorded negative returns. Yields for the one-year category — average returns for all arbitrage funds — also fell to 3.6% as of January 1, 2021, according to data from Value Research. Over the past three and five years, these funds have posted an annualized return of 5.1% and 5.6%, respectively.

Arbitrage funds are suggested by my many investment advisors as an alternative to liquid plans for investors in higher tax brackets. Because hedge funds are classified as equity funds, they are tax-efficient for those in the highest tax brackets – 20% or more.

Should investors stay away because of their recent performance? “They may still make sense for some investors depending on their tax bracket and investment horizon. However, at this stage, debt funds that invest in short-term paper could do better,” said said Malhar Majumder, partner, Positive Vibes Consulting and Advisory, a company that distributes financial products.

We tell you why arbitrage fund returns are low and whether you should invest.

LOW YIELDS

Arbitrage funds aim to capture the price difference between the spot market and the futures market. The spot market, also known as the cash market, is where securities are traded for immediate delivery, while in the futures market, participants buy and sell futures contracts on commodities and term for delivery at a specified future date. These opportunities are greater when the markets are volatile, as this can lead to a wider price difference (or spread) between the spot market and the futures market.

“Sometimes this spread can turn negative, when the futures market is discounting the spot. Typically, this happens when market sentiments are bearish,” said Kaustubh Belapurkar, Director of Fund Research, Morningstar India Advisor, a platform that offers mutual fund research and investment management services In April and May, market sentiment was negative due to covid -19.

SHOULD I INVEST?

If you are in the highest tax bracket, under specific circumstances it may still make sense to invest in hedge funds. Their one-year returns are comparable to those of liquid mutual funds.

“Over the past calendar year, the arbitrage fund category has averaged a return of 4.2% and the liquid fund category’s returns are 4%. After-tax returns from hedge funds would be better than liquid funds for those in the higher tax brackets,” Belapurkar said. Arbitrage fund returns exclude Essel arbitrage fund, which returned 0.94% and Value Research data shows its corpus zero. .

If you invest in an arbitrage fund, keep a minimum horizon of 6 months, and don’t worry about certain periods of negative returns.

“Investors shouldn’t worry about short periods of negative returns. The way the product is structured, it doesn’t give negative returns if you hold it for longer than six months,” Majumder said.

If you redeem your hedge fund investments for up to a year, the profits will be taxed as short-term capital gains (STCG). The tax treatment of hedge funds is the same as that of any other equity fund. You will pay a 15% tax on STCG.

In the case of liquid funds (or debt regimes), profits are taxed as STCG for up to three years. If you withdraw before three years, your gains are clubbed with your earnings and tax is payable at the marginal rate.

If you are in the 20% or 30% tax bracket, and if the returns from liquid and arbitrage funds are the same, your after-tax returns would be higher in arbitrage funds if you withdraw within three years after the investment.

If you redeem after one year, there is no income tax until 1,000,000. Any winnings above this are taxed at 10%.

Under certain market conditions, arbitrage opportunities are limited. If you pull it off, you can still get better after-tax returns in arbitrage funds compared to short-term debt funds.

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