Arbitrage funds are equity oriented funds and short term capital gain applicable is 15% and 10% on dividend income compared to much higher taxation of nearly 34% in liquid funds

The change in debt fund portfolio valuation norms has cast a dark shadow on liquid funds returns. As liquid fund managers tweak their portfolios to shorter-term papers in a bid to side-step mark-to-market risks to their portfolio, yields on liquid schemes could moderate. In this backdrop, fund houses like Edelweiss AMC have started pitching arbitrage funds as a better alternative. The pitch is new, but the comparison is not. Arb funds, as they are popularly called, have been regularly compared with liquid funds because arbitrage funds can give stable liquid fund like returns but have a slim tax edge. RupeeIQ takes a closer look at the issue.

Market regulator Sebi has come out with operational details on how fund houses should do the valuation of money market and debt securities of short term maturity. On the face of it, those schemes, like liquid funds, which maintain exposure to securities with a residual maturity under 60 days will be impacted.

As an after effect of credit events in September 2018, causing a sudden spike in money market rates affecting the returns of liquid funds investors, Sebi revisited the valuation norms to better reflect market risks within the liquid fund category. All the debt securities beyond 30 days maturity would be subject to daily mark-to-market (MTM) which was not the case earlier.

Earlier securities beyond 60 days were subject to daily MTM. Hence, most liquid funds were immune to small movement in the yield. With the change in valuation norms, a significantly higher proportion of the portfolio will be revalued daily which may have adverse impact on fund predictability and volatility, Edelweiss MF says.

The average 1-year return of liquid funds at present is 6.9%. But there is a wide variance in returns. The best fund i.e.Aditya Birla Sun life Liquid Fund(regular plan) has got 7.5% return but the worst fund i.ePrincipal Cash Management Fundhas actually lost money (down 1.8%).

One way to reduce the adverse impact of Sebi valuation norms may be to reduce the duration of the portfolio towards 30-day maturity. As the fund managers shift their portfolio to shorter-term papers to avoid mark-to-market risks of their portfolio, yields on liquid schemes could moderate. Currently, the spread between 30-day and 60-day papers is somewhere between 50 to 60 basis points. If the fund managers start reducing the duration of the fund in order to attain lower volatility and demonstrate predictability, investors may get relatively lower return compared to present returns, Edelweiss MF adds.

Arbitrage funds work on the mis-pricing opportunities in equity shares in the spot and futures market. They are not debt-oriented instruments like liquid funds.

In arbitrage funds, the fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives market. The difference in the cost price and selling price is the return you earn. This return is small and is comparable to liquid funds. The best-performing arbitrage funds have generated 6% in last one year.

Arbitrage funds have a tax advantage edge over fixed deposits, and bond/debt funds. These funds are treated as equity funds for the purpose of taxation. Instead of sticking to pure debt funds, these funds are suitable for conservative investors who are in higher tax brackets to earn tax-efficient returns.

Arbitrage funds are equity oriented funds and short term capital gain applicable is 15% and 10% on dividend income compared to much higher taxation of nearly 34% in liquid funds.

Kumar Shankar Roy is contributing editor with RupeeIQ. He can be contacted on

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