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Why arbitrage funds are no longer a great investment

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Why arbitrage funds are no longer a great investment

Due to rising assets under management, the returns from arbitrage funds are likely to fall further.

Since arbitrage funds make money from low-risk buy-and-sell opportunities available in the cash and futures market, their risk profile is similar to that of a debt fund.

Investorinterest inarbitrage fundshas seen a spike since the long-term holding period for debt funds was increased from one to three years. Since arbitrage funds are treated as equity funds, their holding period for long-term capital gain is one year. Long-term capital gain from equity is tax-free (short-term capital gain is taxed at a concessional rate of 15%). Equally importantly, the dividend income from equity does not attract dividend distributiontax.

Since arbitrage funds make money from low-risk buy-and-sell opportunities available in the cash and futures market, their risk profile is similar to that of a debt fund. In fact, most arbitrage funds use Crisil Liquid Fund Index as their benchmark. So, arbitrage funds bring to the table the best of both the equity and the debt world. Thats not the whole picture though.

Even as arbitrage funds offer several benefits, their net impact seems to be all but negated on account of falling returns of these funds. The category average oneyear rolling returns for arbitrage funds have come down drastically from 8.07% a year back to just 6.38% now. This 6.38% return is significantly lower than the historical return of 7.74% and 8.78% generated by competing products such as liquid funds and ultra short-term debt funds respectively.

The historical post-tax returns across tax slabs(see bar graph)show that arbitrage funds have been of some use to only investors in the highest tax brackets. So, why are returns of arbitrage funds falling? Though the recent stock market sluggishnessthere are more arbitrage opportunities in a buoyant marketis one reason, a sudden spike in inflows to arbitrage funds is primarily responsible for this. The ability to generate returns comes down when more money chases the same arbitrage opportunities, says Rajiv Radhakrishnan, Head, Fixed Income, SBI Mutual Fund.

The assets under management (AUM) of arbitrage funds continue to bulge: The collectiveAUMof arbitrage funds jumped Rs 5,403 crore in one month, taking the total AUM of arbitrage funds to Rs 31,669 crore in August. If such inflows continue to arbitrage funds, their return profile will come down further, says Prateek Pant, Head of Products and Solutions, Sanctum Wealth Management. Investors need to make a realistic assessment of the value of arbitrage funds to their portfolio. Theres no need to rush in.Not making enough money in stocks? Click here for real-life stories of successful investors.How new tax changes will impact you. Calculate your tax nowRead more oninvestorTaxaumET WealthArbitrage fundsAlso Read

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