Should you replace debt funds with arbitrage funds to save tax?

After the shock change of debt fund taxation with effect from 1st April 2023, arbitrage funds are starting to get more attention as a replacement for debt funds owing to their superior taxation. However, does the tax advantage always work in these funds’ favour across the debt fund categories and across tax brackets? In this article, we will explore suitability of arbitrage funds and compare it with relevant debt fund categories.

What are arbitrage funds?

Let’s get the basics explained first. Arbitrage funds aim to make profits through mispricing opportunities in the cash and futures market. These funds simultaneously enter into buy and sell transactions in the cash and futures market to lock into the price difference and, in doing so, minimise the risks. 

For example, a fund will buy a stock in the cash (spot) market and will simultaneously sell its futures for a higher price. At the date of expiry, the security is sold in cash markets to lock in the profits earned, which is the price difference between cash and futures market at the time of purchasing the security. Volatile markets offer more arbitrage opportunities than flat markets.

Arbitrage funds use these derivatives (futures and options) to get into offsetting positions on their entire equity exposure, meaning that there is virtually no part of the equity holding that is exposed to risks in market movements. The net equity, effectively, is close to 0. A typical arbitrage fund also invests up to 35% in debt instruments.

It is this that makes arbitrage funds a low-risk option.

Taxation of arbitrage funds vs debt funds

As per current tax laws, a mutual fund is eligible for equity taxation if it invests at least 65% of its portfolio in domestic equity instruments – which includes derivative instruments. This means an arbitrage fund is taxed as an equity fund, despite it not being exposed to equity market risks.

From the taxation point alone, arbitrage funds are a clear winner over debt funds. But tax alone cannot be a factor, as returns earned by the funds also matter. Therefore, comparing returns of arbitrage funds against the different categories of debt funds will help gauge how far arbitrage funds can be used as replacements.

How do the returns compare?

To compare with arbitrage funds, we looked into investment durations up to 2 years. This is because of 2 reasons:

1. The returns of an arbitrage fund are mostly comparable to debt funds that invest in shorter term debt securities.
2. For a duration of more than 2 years, if you are looking at arbitrage funds because of their better taxation compared to debt funds, you would be better off with equity savings funds. Though the equity savings category is more volatile than arbitrage funds due to unhedged equity exposure (around 10% to 30%), the risk is reduced over a 2 year (and longer) period. Similarly, for even longer timeframes, balanced advantage funds offer a good option.

To compare returns of debt funds with arbitrage funds, we looked into rolling returns over the past 5 years, which represents a full interest rate cycle. Returns of arbitrage funds for each specific investment period were compared against returns of specific debt categories that are best suited for the duration of investment. Let’s delve into each of the return periods.

[Note: Many debt funds faced write offs and write backs in the past few years. Such funds have been omitted from the calculation of category averages.]

Liquid funds

We compared arbitrage funds against liquid funds over 1 month and 3 month periods. There are a few observations here.

One, purely on returns alone, liquid funds have beaten arbitrage funds about 44% of the time on rolling 1-month returns over the past 5 years. Over a 3-month timeframe, the liquid outperformance drops to 31% - but the return differential is minimal. The average 3-month return is just about 0.07 percentage points better in arbitrage funds. That makes the tax impact the primary influencing factor in opting for arbitrage over liquid funds for very short-term periods. 

Two, the arbitrage category’s day-to-day return is very volatile compared to the mostly steady growth of the liquid funds. This, along with the lower 1-month returns, makes arbitrage funds relatively unsuitable for running STPs, since there’s a chance that you may be redeeming on poor returns. In our observations, we found that arbitrage funds have faced one month losses occasionally, in about 0.4% of cases against 0% for liquid funds in the past 5 years.

Therefore, let’s turn to the tax factor. 

• In the lower tax brackets of 5-15% (old and new tax regimes), liquid funds are a better option and there is no necessity to go for arbitrage funds. In the very low tax slabs, post-tax liquid returns and outperformance is superior to arbitrage.
• In the higher tax brackets, arbitrage funds provide an advantage. In a 3-month period, for example, these funds clearly maintained lead over liquid funds. In the 30% tax slab, arbitrage funds outperformed liquid funds in close to 90% of observations. The average return differential improved from 0.07 percentage points to 0.25 percentage points. While this is not a significant difference, for those of you keen on saving taxes and where investment amounts are large, arbitrage funds can be a liquid substitute. However, note that arbitrage funds are more volatile, and are not as low risk as liquid funds.

Six months - ultra short/low duration/ money market

In our observations, we noticed that on category average 6 months returns, all three debt categories outperformed the arbitrage funds. Ultra short and money market funds beat the arbitrage category in ⅔ cases and the outperformance rises to ¾ in the case of low duration funds. The average return differential swells to about 0.41 percentage points, and at the peak, the difference between the average arbitrage return and the 3 debt category returns is close to 1 percentage point.

However, the rate cycle appears to influence the pattern of returns. All 3 debt categories markedly outperformed arbitrage funds over a falling interest rate cycle, when these funds would benefit for a while as they would hold papers bearing higher coupons. At the bottom of the rate cycle, these would eventually even out putting them similar to arbitrage funds. 

With the better returns in debt funds, on a post-tax basis, here’s how you can view arbitrage funds:

• Those at the 30% tax slab will find arbitrage funds giving higher post tax returns over debt funds, especially when rates are at the bottom or even on an upward trend.
• Those in the 20% tax bracket could combine arbitrage funds along with ultra short/low duration/money market funds for a mix of tax efficiency along with superior return options.

Those in the lower tax slabs can stick to pure debt funds.

To view more details on outperformance by arbitrage funds over each debt fund category for each tax slabs, refer to the Arbitrage funds vs Debt funds spreadsheet

One year - ultra short/low duration/ money market

With 6-month returns of these debt funds already superior to arbitrage funds, the longer 1-year period will clearly reflect the same trend. The outperformance of the debt categories over arbitrage was 3 out of 4 times. 

But what becomes advantageous to arbitrage funds in this period is the long term capital gain tax. For arbitrage funds, tax is 10% above a gain of Rs.1 lakh. Do note that this Rs.1 lakh limit is for entire equity investments (including stocks, equity mutual funds etc). The below analysis is based on 10% capital gains tax and not considering Rs.1 lakh exception.

After applying the long term capital gains to arbitrage funds:

• Those in the 30% tax bracket will get even better post tax returns from arbitrage funds compared to all the three debt fund categories we compared it against. 
• For those in the 20% bracket, we find the post tax returns and instances of outperformance are fairly close. Low duration funds have shown a better performance over arbitrage funds for this bracket also, but that could be because some funds in this category take marginal credit calls, which ups the average. Otherwise, for those in this tax bracket, arbitrage funds remain a good option.

For those who were in 15% or lower brackets, debt funds continue to give higher post tax returns with more instances of outperformance.

To view more details on outperformance by arbitrage funds over each debt fund category for each tax slabs, refer to the Arbitrage funds vs Debt funds spreadsheet

Two years - short duration

For a 2- year period, we compared arbitrage funds against short duration debt funds. Short duration debt funds usually have higher yields compared to the debt fund categories we checked until now (liquid, ultra short, money market, and low duration) and they are also more affected by the change in interest rates. 

This was seen in our analysis as the return differential between short duration and arbitrage funds were close to 4.7% CAGR (10.4% for short duration vs 5.7% for arbitrage funds) during the downward interest rate cycle of 2018 Nov to 2020 Nov. The average returns were also considerably higher to make a strong case for the short duration funds (5.44% for Arbitrage vs 7.01% for short duration).

The strong outperformance of short duration funds means even for the 30% tax slab, the average post tax returns of short duration funds matches that of arbitrage funds. While there may be pockets of post-tax outperformance in arbitrage funds based on the rate cycle, the difficulty of predicting rate cycles means that it is better to pick short duration funds over arbitrage funds irrespective of their tax slab.

For more details on return distribution and impact of tax for various slabs, you can refer to this spreadsheet.

Conclusion

While arbitrage funds do have better taxation over debt funds, the lower returns compared to most debt fund categories make arbitrage funds an inferior option for most of the lower tax bracket investors. Investors in the highest tax bracket can generate better post tax returns using arbitrage funds. However, always bear in mind that arbitrage funds are not debt funds even though they are low on risk. Do not invest your entire debt portion in arbitrage funds, and try for a mix to balance tax efficiency, risk and return.