What are arbitrage funds? When are these funds appropriate for you?

In the last couple of years, one category among the mutual funds has gained popularity – the arbitrage funds. It is important to understand what these funds are, how they work and what purpose these serve. One must also understand the risks involved in these funds. Click here to read my article published in Mid-day Gujarati edition.

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The English translation of the article is as under:

What are arbitrage funds? When are these funds appropriate for you?

In the last couple of years, one category among the mutual funds has gained popularity – the arbitrage funds. It is important to understand what these funds are, how they work and what purpose these serve. One must also understand the risks involved in these funds.

We covered this category in our column on February 6, 2017 with proper example. However, we feel that there are a few misconceptions around this category that need to be clarified, especially looking at the amount of money getting parked in these funds. Many consider this as safe as liquid funds, with the benefit of lower (or zero) taxation.

Arbitrage is a strategy to generate returns due to the price difference between two different markets for the same (or similar) securities. This often happens between the cash segment and futures segment of the stock markets, on account of what is technically known as the “cost of carry”. This “cost of carry” is akin to interest charged for short term borrowing.

However, since the money is invested in stocks (at least 65% of the scheme’s corpus), the fund is treated as “equity oriented fund” according to the Income Tax Act. This means the dividend is tax exempt in the hands of the investor, as well as exempt from the dividend distribution tax. Capital gains are tax-exempt, if the holding period is more than one year. Even when the capital gains are booked for a holding period of less than a year, the same is taxed at a lower rate of 15% and not clubbed with the income.

This tax arbitrage is drawing a lot of money towards these funds. However, it is important to understand the investment before getting on to the discussion of taxation. The investment theory must precede considerations of tax and the investment theory would help one analyse the risk-reward trade-off.

First of all, let us make one point clear: as per the classification for purposes of income taxes, arbitrage funds may be classified as equity-oriented funds, but in terms of investment theory, these are alternatives of liquid funds. Hence, please do not expect returns in line with equity funds. These funds can generate investment returns very similar to those generated by liquid funds.

At the same time, while liquid funds invest in money markets and debt markets; arbitrage funds exploit arbitrage opportunities between two different segments within the equity markets.

Pure arbitrage is considered to be an almost zero risk strategy, since the prices converge on expiry of the futures contract. However, there is a possibility that the spreads widen before the contract expires. In such a case, there could be negative returns, temporarily. One must be aware of this.

Such short term negative returns may coincide with your parking horizon and thus, you may end up with very low or even negative returns, if you have parked money for very short periods of time. This only means that one should not treat arbitrage funds as a total replacement of liquid funds, but use these only when the time horizon is slightly long, say at least one month.

In spite of the risk highlighted, the arbitrage fund could be a good place to park your fund and enjoy the reduced taxation.

-       Amit Trivedi

What to see while selecting a liquid fund to invest in ...

What should one consider while selecting a liquid fund? Read my article in Mid-day Gujarati edition on 22nd February here ...

http://www.gujaratimidday.com/business/expert-opinion/expert-views-on-mutual-funds-15


The English translation is as under:

Sometime ago, we saw what to look for if one wants to compare two or more different equity funds. Today, we will discuss how to choose a liquid fund (or ultra-short term bond fund – most retail investors may be fine with the latter and in this article, we will use a common term “liquid fund” for both these categories). In order to decide on the selection criteria, it is important to first identify the objectives for parking money in a liquid fund.

Primarily, there are three reasons why people use liquid funds, (1) as a contingency fund, (2) to park money which would be used for some expenses in the short term, or (3) to temporarily park money meant for investment in equity funds later (at an opportune time or through systematic transfer).

To begin with, let us understand one thing common in all the above objectives: one is looking at (1) safety of capital and (2) easy and convenient liquidity. If the returns are high, it is an additional benefit, but not the primary purpose for investing in liquid funds.

Let us first look at the third of the three objectives listed above, “to temporarily park money meant for investment in equity funds later (at an opportune time or through systematic transfer).” In this case, the objective is to earn higher returns through equity investment. The liquid fund is used only for the purpose of temporary parking. The question here is not about selecting a liquid fund, but of selecting an equity fund. Once you have done that, you need to invest in the liquid fund of the same fund house to enable smooth transfer whenever required. You need not spend too much time on selection of the liquid fund in such a case.

That leaves the first two objectives of putting money in liquid funds. In both cases, the critical point is to get the money as and when needed, without loss in value. Hence, the critical factors to evaluate the schemes should be (1) safety, (2) convenient liquidity, (3) ease of transaction, (4) timely and hassle-free credit of the money in your account when needed.

Let us start with evaluating safety in a liquid fund. We have highlighted earlier that mutual funds are structurally superior to most products on this count. However, even within that, different liquid funds may have different risk levels.

First of all, liquid funds invest predominantly in debt and money market securities issued by companies and banks. These corporate papers carry a risk that the companies may default on their commitments. In such a case, it is wise to check the credit rating profile of the funds. The second thing you need to look at is the average maturity of the portfolio. The lower the average maturity, the safer the fund. You must check this in case of ultra-short term bond funds, but need not worry about the same if you are investing in a liquid fund. In case of liquid funds, SEBI regulations do not allow the fund to invest in any paper having maturity beyond 90 days.

Points no. 2, 3 and 4 would be almost the same for all the funds, except you may want to be doubly sure that the fund does not have any exit load even for a very short period. Since you are investing for an unknown period, exit load may be avoided. You need to check the exit load only at the time of your investment, as the same is applicable for all prospective investments and not on retrospective basis.

Many fund houses these days offer SMS based or App based transactions. These allow extra convenience as you can seamlessly transfer money from your bank account (if registered for the same purpose) to the fund and vice versa.

One more thing, expenses matter in case of liquid funds. Check the expense ratio before investing.

Liquid funds are the easiest products among the mutual funds to understand and benefit from.

So go ahead, and make use of these funds when you have surplus money to be parked for short periods.

-        Amit Trivedi

The author runs Karmayog Knowledge Academy. Recently, Amit has authored a book titled “Riding the Roller Coaster – Lessons from Financial Market Cycles We Repeatedly Forget”. The views expressed are his personal opinions.

What are liquid funds?

My article explaining liquid funds in Mid-day Gujarati today:

Understanding liquid funds

The English translation is given below:

According to a lot of people, all mutual funds are equity funds. One of the reasons behind this myth is the regular risk line that appears in all mutual fund communications, “Mutual fund investments are subject to market risk.” The words “market risk” have a very strong association with equity. So many investors have heard of equity markets, very few know about debt markets or money markets.

This is why not many know of the largest category among mutual funds – the liquid funds. This is a category of funds that helps one park money for very short periods.

If you are running your own business, there are periods when some surplus may be lying in your current account with the bank. This may be shifted to a liquid fund. So let us understand what liquid funds are and how these work.

Liquid funds invest in debentures with very short maturity. Earlier, these liquid funds used to invest in debentures with maturity less than 18 months to 2 years, with average maturity of less than 6 months. However, according to recent SEBI guidelines, liquid funds can invest in instruments with maturity not exceeding 90 days. Such guidelines only ensure that when the investor is looking at a liquid fund with a very short term view, the underlying investments also should be of short maturity.

What does the above mean to an investor? Well, an investor who needs to invest money for a period as short as 2 days can consider liquid funds. The liquid fund offers higher returns than interest paid on the savings account with instant liquidity and high safety of capital. Ever since liquid funds came into existence more than a decade back, there have been only two instances when the NAV (NAV of a mutual fund is the realisable market value of units) of some of the liquid funds were lower than the previous day. This shows us how low is the probability of losing money in liquid funds even for a single day. One must remember that the decade has been marked with certain periods of crisis never before witnessed by the present generation.

What are some of the applications of these liquid funds?

For starters, any money lying idle in a bank account for more than a week should be put in a liquid fund. I know of a friend, very money savvy, who used to purchase his monthly household items using his credit card, while simultaneously putting equivalent amount of money in a liquid fund to be withdrawn couple of days before the credit card bill payment date. This allowed him to earn even on the money he had spent. However, one must be very careful with such a strategy as missing the date with the credit card could be a lot costlier than what one can earn through the liquid funds.

Another application of liquid funds is ideal for businesses – be it small or large. In businesses, the cash flows are highly uncertain and hence periodically the business may end up with huge surplus. Such money can be invested in a liquid fund as it allows the flexibility to invest money for period as short as two days to as long as forever. When one is not certain when the money would be needed, liquid funds are the ideal choice.

Large companies with surplus cash also invest idle money in liquid funds, which is withdrawn when there is a need for capital investment, acquisition, business expansion, etc.

In the heydays of IPOs (Initial Public Offering) by companies raising money from the stock markets, many investors used to roll the money over from one IPO to another, either the money received as refund or the realisation on sale of shares on listing. The money lying idle between such opportunities was parked in liquid funds.

As mentioned earlier, liquid funds offer marginally higher return compared to savings bank account with high degree of safety.

Please remember that investment in liquid fund is all about convenience rather than returns. Your primary need is to get money when you need. Over last few years, mutual fund companies have introduced certain innovative practices to make it even more convenient. We have a facility to transact in liquid funds with the help of SMS or Internet. Some funds offer a debit card facility along with your liquid fund account. You may go to a bank ATM and withdraw money as required directly from your liquid fund account.

Choose a mutual fund advisor who can help you with multiple transactions in liquid funds. Check with one before you start the relationship.

You need not spread your money across many funds, one may be enough.

Amit Trivedi

The author runs Karmayog Knowledge Academy. The views expressed are his personal opinions.