Equity savings funds are the latest type of asset allocation mutual funds introduced first in late 2014 when the government made the duration for debt mutual fund capital gains to be classified as long-term from 1-year to 3-years.

Equity savings funds are basically arbitrage+equity+ debt funds. They would hold a minimum of 65% equity (most of it in arbitrage opportunities) to be classified as an equity fund by the tax man. The rest would be in fixed income securities. Soon after equity savings funds were launched, I had called themnew Chinesedosa! A needless category with only one purpose to attract the AUM lost from debt funds (due to unfavourable debt fund taxation).Now that they are here to stay, let us find out if they can put to some use.

First, do allow me to take a swipe at the star ratingsystem. Star rating is a form of peer comparison. The key-word is peer. Which means the group has to similar in nature if not identical.

If you head over to theHybrid: Equity-orientedsection at Value Research, you will find equity savings funds in the same group as equity-oriented balanced funds. This is downright ridiculous. Yet another reasonwhy you shouldignore mutual fund star ratings.

So I got this category, exclude direct funds (or regular funds) for clarity and arrange them in order of launch date in descending order.

I was under the wrong impression that equity savings funds are arbitrage oriented balanced funds. That is, they hold 65% arbitrage +35% bonds. This is wrong!

They can actually hold significant amounts of direct equity! That is they can have anet long equity exposure.In other words, the extent to which they can buy stocks (go long) can be more than the extent to which they short them (net is positive up to 40%)

This net long equity exposure is aimed to gain from potential capital appreciation and thus is a directional equity exposure which will not be hedged. This equity exposure means exposure to equity shares alone without a corresponding equity derivative exposure

-Presentation leaflet: HDFC Equity Savings Fund

While I do not know ifallequity savings funds holddirect equity, I do see that many of them do. Also, each fund in this category can be quite unique. For example, Axis Equity Saver can invest up to 50% in foreign securities.

Therefore, it is incorrect on my part to have compared Equity savings funds with Arbitrage funds.

As of now, in terms of risk and reward,Equity savings funds are a notch above Monthly Income Plans (MIPs) which can hold up to 25-30% direct equity and a couple of notches below equity-oriented balanced funds. I conclude this by comparing the standard deviation of these funds.

Note: some equity savings funds are old ones. They were probably remodelled after budget 2014. So the exact picture will emerge only a little later. At best, equity savings funds could become comparable to MIPs down the line.

Arbitrage funds can be compared to ultra short-term funds or short-term gilt funds.

Equity savings funds are recommended by AMCs for above 1Y durations. Which is why they have an exit load of ~1% for redemptions within 365 days. This means (regular readers may be aware why) that they are suitable for 5Y+ durations!

I would suggest using them forintermediate term financial goals(5-10 years or so). Theystill carry some amount of risk as they aim for capital appreciation.

Arbitrage funds can be used from just a few months to any number of years. Arbitrage funds do not have an exit load above (15 days 90 days). I would recommend using them for 1Y and above durations. A portion (only a portion) of your emergency fund can be put here. Note that these funds can give negative or near-zero monthly returns.

First, I recommend reading a non-technical description ofhow arbitrage mutual funds work. In a nutshell, they exploit the price different of a stock in the cash market ( where the transaction is instant stocks exchanged for current price ) and the derivatives market (where stocks are exchanged at a future date at the current price).

Buying a stock in one market and sellingthe same stockin another market is known what I refer to aspure arbitrage.The price difference gradually converges to zero when the date of settlement approaches. This results in gains (= price difference) which is low risk.

If there is a pure arbitrage, there should be an impure arbitrage -the security purchased in one market is different from that sold in another! This is done in the hope that price of these two securities converge at a future date (due to some anticipated event). If this does not happen, it could lead to disaster. An extreme example is the collapseof US hedge fund, Long-term capital management because of an impure arbitrage bet gone wrong. Read more:Review: Riding The Roller Coaster -Lessons from financial market cycles we repeatedly forget

This is how HDFC Equity savings scheme would invest (emphasis is mine):

The exposure to derivative shown in the above asset allocation tablewould normally bethe exposure taken against the underlying equity investments and in such case, exposure to derivative will not be considered for calculating the gross exposure

So the fund normally take only pure arbitrage bets!

DSP Black Rock savings fundhas a more attractive policy: cash-futures arbitrage refers to equity exposure completely hedged withcorrespondingequity derivatives. I like this strategy better!

The risk from impure arbitrage bets is probably small in equity savings funds and arbitrage funds. However, I would prefer looking into the scheme information document and to check the latitude that the fund manager has. I do not want them taking undue risks just because pure arbitrage opportunities are not attractive or not available.

Equity savings funds typically have the mandate to change asset allocation if arbitrage opportunities are not available or if debt returns are more favourable. This is not something that I am comfortable with, but that is the way it is.

This is how I would choose Equity savings and arbitrage funds:

Search for a fund in the above list that does not invest in direct equity- only arbitrage + debt. If such a fund is available and if that fund invests in pure arbitrage, go for it! Most likely such funds are not available.

Else settle for one with small direct equity exposure + pure arbitrage. The debt portion should have money market and short-term bonds.

Select funds which only deal in pure arbitrage bets. No direct equity, no fixed income. Recognise that the fund category in VR is called Hybrid: arbitrage! Not just arbitrage.

Fund named, enhanced arbitrage; arbitrage plus; etc. are probably hybrid funds with a bit of fixed income and probably a pinch of direct equity.

Look for funds named equity arbitrage, arbitrage opportunities and study their scheme documents in detail.

These categories cannot be picked by looking at returns. I also suggest you do not pick themforreturns! Expect anything between 6-8% from them. No more.

Freefincal Q & A: Ways to Use Equity Savings Funds

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Sir, Can arbitage funds be used to park money in debt till the time equity appears overheated and shift from arbitage to equity during equity correction?

Can you suggest an arbitrage fund and an equity savings fund? Would you recommend a PURE arbitrage fund? What options would a pure arbitrage fund have if arbitrage opportunities are not available? Would they simply hold cash?

I was considering ICICI Equity Arbitrage and Kotak Equity Savings. Advise?

Sir can you please share which fund/funds are better for getting regular monthly/quarterly income from 1 time lumpsum investment with higher degree of safety.i.e. with proven track record of higher % returns in monthly income. Should I go for Monthly income plans/ Swp plans / dividend paying funds etc.. it is very confusing, so request you to please list from your experience 4-5 funds that I can study and invest.

I provide tools for you to shortlist and do not provide lists myself.

it is said that the Arbitrage funds do well (like liquid funds) during bull run, and under perform during (like SB account interest rate)falling markets, so is it better to stop investing in arbitrage funds in bearish market? I have 3 year SIP into arbitrage fund for emergency fund, should I shift it to liquid fund in bearish market?

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