Do you know the answer to the Arbitrage funds vs Debt funds debate?

3 minute read

In our earlier post here we had discussed the various factors which impact the returns of an arbitrage fund. Today, let us explore the taxation advantage of an arbitrage fund over debt fund.

Taxation for Arbitrage funds vs Debt Funds

arbitrage-vs-debt-taxation

Arbitrage funds are classified as equity funds and hence the returns do not get taxed after 1 year

The major taxation differential between arbitrage fund and a debt fund primarily kicks in for a 1 to 3 year investment horizon

Arbitrage funds enjoy taxation advantage over Ultra Short Term Debt Funds..

arbitrage-vs-ust

But Ultra Short Term funds generally have slightly better returns over arbitrage funds on a pre tax basis

Historically, on a 1 year basis, Ultra short term fund returns have been higher by around 0.5% to 1% over arbitrage funds on a pre tax basis

compare-funds-rolling-returns-for-a-period-relative-to-its-peers-and-category-averageSource: http://thefundoo.com/Tools/SchemeRollingReturns

Note: Kotak Equity Arbitrage and Kotak Treasury Advantage have been used as a proxy for Arbitrage fund and Ultra Short Term Debt fund category. I have only used the data from Jan 2013 as the arbitrage fund category had undergone some changes in the way they are managed (which is beyond the scope of this article) and hence earlier data comparisons wouldn’t be too relevant.

So, putting all this together, for investment periods between 1 to 3 years

  1. Investors @10% taxation bracket
    The taxation advantage of around 0.5 to 1% for arbitrage funds over  Ultra Short Term fund gets compensated by the o.5 to 1% pre tax return disadvantage of arbitrage funds over Ultra Short Term funds.Hence investors in the 10% tax bracket can continue with Ultra Short Term funds for 1-3 year investments given their relatively lower volatility
  2. Investors @20% taxation bracket
    The taxation advantage of around 1.5 to 2% for arbitrage funds is higher than the 0.5% to 1% pre tax return advantage of Ultra Short Term funds.So typically there is still a 0.5% to 1.5% post tax return advantage in arbitrage funds over Ultra Short Term funds for investors in the 20% tax bracket.
  3. Investors @30% taxation bracket
    The taxation advantage of around 2% to 2.5% for arbitrage funds is higher than the 0.5% to 1% pre tax return advantage of Ultra Short Term funds.So typically there is still a 1% to 2% post tax return advantage in arbitrage funds over Ultra Short Term funds for investors in the 20% tax bracket.

    This being said, please note that arbitrage fund returns may go down below our expectations, in case of a 1) bear market 2)reduced borrowing and hedging cost for FII or 3)significant size increase for the category.

Conclusion

  1. Investors in the 20% and 30% taxation bracket who also understand the risk and volatility in the arbitrage fund category may choose an arbitrage fund over an Ultra Short Term fund from a 1-3 year investment perspective
  2. Investors in the 10% tax bracket can continue with Ultra Short Term funds for 1-3 year investments given their relatively lower volatility

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As always happy investing 🙂

Disclaimer: No content on this blog should be construed to be investment advice. You should consult a qualified financial advisor prior to making any actual investment or trading decisions. All information is a point of view, and is for educational and informational use only. The author accepts no liability for any interpretation of articles or comments on this blog being used for actual investments.

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Author: Arun

Hey! I'm Arun and I work for the research team of a boutique wealth management firm based out of Chennai. The idea behind this space is to share my learnings/mistakes and hopefully help people in making better investment decisions :)

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