Should you invest in arbitrage funds after Budget 2024 increased STCG tax? Will this diminish the appeal of arbitrage funds? Read here to find out
With the revision in capital gains tax rates, investors in arbitrage funds will get squeezed. Arbitrage funds essentially take advantage of the price differential between equity spot and futures markets to generate returns. Now, with the tax on short-term capital gains proposed to be hiked to 20% from 15%, investors will face a higher tax burden. Will this diminish the appeal of arbitrage funds?#sr_widget.onDemand p, #stock_pro.onDemand p{font-size: 14px;line-height: 1.28;} .onDemand .live_stock{left:17px;padding:1px 3px 1px 5px;font-size:12px;font-weight:600;line-height:18px;top:9px} #sr_widget.onDemand .sr_desc{margin:0 auto 0;} #sr_widget.onDemand .sr_desc{color: #024d99;margin-top:10px;} #sr_widget.onDemand .crypto .live_stock .lb-icon{8px 6px 5px 3px !important} #sr_widget.crypto.onDemand a.text{border-bottom:1px solid #ccc;padding-bottom:5px;display:block;width:100%} #sr_widget.onDemand .sr_desc .text p, #stock_pro.onDemand .sr_desc .text p{font-size:12px;font-weight:400;} The Budget has proposed higher tax rates for both short-term and long-term capital gains. However, given the specific purpose served by arbitrage funds, the former is more relevant to most investors. These funds are typically held for less than a year, often as a transit station for idle savings. Many opt for arbitrage funds as a more tax-efficient alternative to liquid funds, which invest in interest-bearing securities with maturity of up to 30 days. Mostly used by corporates, these are also harnessed by retail and high net worth investors for parking temporary surplus, or for use as a source fund for transferring regular sums in pure equity funds with a systematic transfer plan (STP).
Till last year, gains in arbitrage funds were taxed at 15% if sold within a year of investment. Meanwhile, gains in liquid funds were taxed at 20% after indexation if sold after three years. Any gains realised within three years were added to the taxpayer’s income to be taxed at the slab rate. For those in higher tax brackets, this tax differential made arbitrage funds more attractive, even when liquid funds were offering a similar yield. So at an indicative yield of 7%, arbitrage funds earlier fetched 5.95% post-tax return, even as liquid funds netted 4.9% in the 30% tax bracket.
Arbitrage funds have delivered good returns in the past year
Now, with the STCG tax rate on arbitrage funds at 20%, it will eat into arbitrage gains. If the indicative yield is 7%, arbitrage funds will net 5.6% post-tax return. Amol Joshi, Founder, PlanRupee Investment Services, says, “The hike in STCG tax further reduces the in-hand gains from arbitrage funds held for less than a year.” For corporates, the impact is tougher to digest. Deepak Gupta, Fund Manager, Invesco Mutual Fund, observes, “Tax arbitrage in this fund category is almost wiped out for corporate investors who are in the 25% tax regime.”
Despite the tax leak, experts insist that arbitrage funds remain highly relevant to investors as a short-term savings vehicle. Santosh Joseph, Founder, Germinate Investor Services, says, “The revised higher STCG tax squeezes the gains from arbitrage funds a bit, but remains beneficial for those in the highest tax bracket.” Gupta points out that the existing investors can get better tax treatment if they hold for longer. “The existing investors could wait to complete a year of holding for it to be classified as long-term capital gain, which will now be taxed at 12.5%.” In fact, if the total capital gains from equities for the financial year do not exceed Rs.1.25 lakh, the gains are tax-exempt. “If you wait till your holding crosses one year, you pay a lower tax of 12.5% only on any gains exceeding Rs.1.25 lakh,” points out Joseph.
Feroze Azeez, Deputy CEO, Anand Rathi Wealth, reckons the prevailing rollover spreads between cash and futures markets matter more for investors in arbitrage funds. “Returns from arbitrage funds vary, depending on the rollover spreads from expiry to expiry. If the spreads are close to or more than the prevailing 30-day treasury bill rate, arbitrage will work in your favour,” says Azeez. Arbitrage spreads are known to ebb and flow, depending on evolving market volatility and trajectory. The amount chasing arbitrage opportunities also influences outcomes. For instance, in 2022, the weakness in the equity markets had led to a drying up of spreads between the spot and futures markets. Arbitrage funds fetched a measly 3.9% return for the entire year, even as liquid funds delivered 4.72%. At the time, liquid funds were positioned to quickly capture the rising yield amid sharp interest rate hikes of the central bank.
Arbitrage funds have enjoyed a good run over the past year. These have clocked a healthy 8.28% return in the direct plan, even as liquid funds have fetched 7.33%. On a year-to-date basis, arbitrage funds have gained 4.88% compared to 4.27% by liquid funds. The heightened volatility in the equity markets leading up to and after the result of the general elections have helped arbitrage funds capture higher spreads easily. While the spreads have narrowed since then, the tax squeeze might cause some moderation in inflows towards arbitrage, which could help prop up spreads going forward, suggests Gupta.
This uncertainty in outcomes from arbitrage funds can be a spoilsport. Comparatively, returns from liquid or ultra short-term debt funds can be fairly stable. This is the reason many choose to park money in the latter. Ultimately, the choice between the two should be guided by multiple factors. Joshi indicates, “We approach scheme selection between debt funds or arbitrage funds based on factors like length of STP duration, tax bracket of investor and prevailing yields.”
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This story originally appeared on: India Times - Author:Faqs of Insurances
