Time to look at arbitrage funds all over again

The AMFI AUM data as on April 30 th 2020 clearly indicates that all the three modes of parking short term funds are quite popular among institutions, corporate and high net worth investors.

May 18, 2020 01:05 IST India Infoline News Service

Where should you ideally park your short term funds? Typically, funds with a 1-year perspective would either be parked in money market funds, low duration funds or at times even arbitrage funds. While money market fund continue to be safe bets due to their focus purely on money market instruments, the Templeton fiasco exposed the risks in low duration and short duration funds. That raises the question of whether investors need to look at arbitrage funds as a serious alternative for short term funds parking. Let us first look at their AUM first.

AUM of Low Duration Funds AUM of Money Market Funds AUM of Arbitrage Funds
Rs74,519cr Rs56,152cr Rs58,705cr

The AMFI AUM data as on April 30th 2020 clearly indicates that all the three modes of parking short term funds are quite popular among institutions, corporate and high net worth investors. However, the question has become more critical after the Templeton case where low duration fund have come under the scanner for their implicit credit risk. Let us look at these 3 categories of funds based on returns, risk and the tax factor.

Returns on low duration, money market and arbitrage funds

Let us look at the Top-4 funds in each of the above categories along with their returns over different time frames. We consider Direct Plans due to their relative cost efficiency. All Fund returns are as on 13th May2020.

Best Performing Low Duration Funds
Scheme Name 1-Year Returns 3-Year Returns 5-Year Returns
Kotak Low Duration Fund (Direct) 8.201% 8.192% 8.780%
Birla Sun Life Low Duration (Direct) 8.808% 8.206% 8.468%
Axis Treasury Advantage (Direct) 8.581% 8.063% 8.221%
DSP Low Duration Fund (Direct) 9.057% 7.890% 8.177%
Best Performing Money Market Funds
Scheme Name 1-Year Returns 3-Year Returns 5-Year Returns
L&T Money Market Fund (Direct) 9.155% 8.151% 8.591%
SBI Savings Fund (Direct) 7.909% 7.706% 8.131%
Franklin India Savings Fund (Direct) 8.106% 7.857% 8.115%
Birla Sun Life Money Manager (Direct) 7.988% 7.818% 7.790%
Best Performing Arbitrage Funds
Scheme Name 1-Year Returns 3-Year Returns 5-Year Returns
Edelweiss Arbitrage Fund (Direct) 7.115% 6.959% 7.002%
Axis Arbitrage Fund (Direct) 6.738% 6.842% 6.956%
Nippon India Arbitrage Fund (Direct) 6.661% 6.970% 6.953%
L&T Arbitrage Opportunities (Direct) 6.748% 7.781% 6.851%
Data Source: Morningstar
Clearly, money market funds and low duration funds appear to have an edge over arbitrage funds in terms of returns, but there are two key things to remember here. Firstly, most debt funds with maturity of 1 year and above have done well due to tepid bond yields in the last two years. That may not sustain going ahead. Secondly, the variance is quite high in returns of low duration funds if you look at the entire universe so fund selection is extremely critical here. Let us now move over to the risk aspect.

Risks in low duration, money market and arbitrage funds

Arbitrage funds can be risky in volatile markets but if you look at the last 10 years, then these funds have consistently given over 6.5% returns. This is after factoring in periods of dull markets where spreads tend to contract. Money market funds tend to be less risky in terms of default risk but they do run an element of interest rate risk. Some of their securities have a maturity of up to 1 year and these bonds can be vulnerable if yields move up. Low duration funds appear to be a little more risky as they also carry a significant element of default risk in their portfolios. Money market funds appear to score on the risk front but we have seen falling rates since January 2015 and things could look different if rates rise. But the one area where arbitrage funds actually score is on the tax front.

How arbitrage funds score on the tax front

Let us assume that an investor allocates Rs500,000 in the best performing fund in each of the above categories. Here is how the post tax returns would look like for a person earning Rs.55 lakhs annually and subject to 10% surcharge.

Particulars Returns on Low Duration Fund Returns on Money Market Fund Returns on Arbitrage Funds
Capital Gains after 1 year Rs41,005 Rs45,775 Rs35,575
Tax Rate including surcharge and cess 34.32% 34.32% 10.40%
Nature of Gains Short Term Gains Short Term Gains Long Term Gains
Tax levied on returns Rs14,073 Rs15,710 Rs3,700
Post Tax earnings Rs26,932 Rs30,065 Rs31,875
Post Tax Yield 5.39% 6.01% 6.38%

If you consider the post tax returns, then arbitrage funds have a small edge. That is because arbitrage funds are classified as equity funds for tax purposes and therefore holdings beyond 1 year is LTCG. This entitles them to concessional tax rate of 10%.

The moral of the story is that when you look at parking short term money, you must look at arbitrage funds also as a savings class. They are fairly efficient and effective in post tax terms!

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