@vikas_nair Hi, I think the scenario has bit changed after introduction of tax on Capital Gain on equity @10% recently. Now, capital gain from equity in excess of Rs.1 lakh are subject to tax. So, ELSS is no longer a tax free instrument. Although, the contribution to ELSS still counts for deduction under section 80C. But, I think this LTCG tax shall have big impact on investor's mind, they will get reduced returns. What do you think?
Arbitrage Funds are mutual funds with an objective to profit from inefficiency in the price of securities in two different markets. We look at their taxation, meaning and difference with liquid funds in this post. The fund invests in equity and debt instruments. The fund manager applies the arbitrage strategy in the equity portion of the fund and for debt portion; it is invested in short-term debts and liquid funds. The profit from arbitrage fund is riskless. The difference in price of securities in two markets in a small range, and it quickly narrows down when a large volume of new positions are added for possible arbitration.
Arbitrage means the difference in the price of a security/commodity in two different markets and the person who does arbitrage is known as, arbitrageur. An arbitrageur in the market always finds for inefficiencies in the market. They purchase a security from the market at a low price and sell it at a higher price in another market. The difference in price is the profit. Arbitrage is regarded as riskless profits. This forms the basic premise of how Arbitrage Funds work.
How Arbitrage funds work:
Inefficiency in price is present in every market. In the financial market, arbitrage strategy can be applied by purchasing stock in the Cash market and selling it at derivatives market at a higher price.
For example: A stock is trading at NSE cash market at Rs.1000 and in Future Market its price is 1200, then the fund manager will buy the stock from the Cash market and simultaneously they will sell the stock at future market. Here Rs 200 is the profit for trade. As the future market has an expiry date for the contract, the fund manager will sell the stock at cash market previously it has bought and will buy the stock in the future market, to cover the position. As the expiry date in Future market nears, the price difference also narrows down and trades at the same price in both markets.
The transaction cost in arbitrage funds is higher because it involves buying and selling of securities in two different markets and has to cover the position at the end of expiry of the future contract.
Arbitrage Funds Risk & Return
Arbitrage funds carry a moderate to low risk to investment. Opportunities for arbitrage comes when there is volatility in market, stable market does not provide much opportunity for arbitrage. The risk associated with equity holdings are reduced by hedging against the derivatives.
The main objective of the funds is to generate a maximum return with less risk associated. Historically, top performing arbitrage funds have given a return of 7-9% from its investment 5-10 year period. The return of mainly depends on the ability of the fund manager to spot arbitrage opportunities in the market. More the opportunity more is the return.
Arbitrage Funds Taxation
In terms of return, Arbitrage funds and Debt funds give a similar return but in terms of taxation Arbitrage funds score over debt funds. Arbitrage funds are considered as equity funds because a fund with more than 65% holding in equities is classified as an equity fund. In, equity fund the investment over a period of 1yr is considered as a Long term and is tax-free. For investment under 1yr period, the gains are taxed at 15% as short-term capital gains tax. But for debt funds, Investment over 3 yrs is considered as a long term and it is taxed at 20%, after indexation benefit. For a period of less than 3yrs is considered as a short term and gain is taxed at 10%.
Comparison between Liquid Fund and Arbitrage fund
Liquid Fund: Liquid fund invests in money market securities like a certificate of deposits, Treasury bill, term deposits with maturity up to 91 days. These funds are highly liquid in nature and carry low risk to investment and have no exit load on redemption of the investment. These funds are suitable for short term period and to manage short-term liquidity requirement. The investment can be redeemed within 24 hrs.
Arbitrage Fund: Its portfolio is a mix of equity and short-term debt instrument. It is suitable for an investment period of 1-3 yrs and carries moderate to low risk to investment. Most arbitrage funds have exit load of 0.25% to 0.50% for 3months and it takes 3-4 business day to redeem the investment.
The main difference between the two funds is the taxation of gains which is discussed earlier in the article and due to taxation benefit, lately arbitrage funds have able to increase their AUM.
In a first look, arbitrage funds seem to have a more complex investment strategy, but on a closer look, it's not very difficult to get into with its investment strategies. The fund is not suitable for long-term wealth creation as there are many other options in equity funds with a better return in long term duration. It's ideal for investing the surplus money for shorter duration in a tax efficient way compared to fixed deposits and one has to stay invested for more than 1yr time period to get the benefits of taxation. Investors should also note that the fund does not favor any specific bull or bear market. The fund performs well only in volatile markets as the probability of price difference increases.
Taxation treatment is an important aspect of investment in Debt Funds. This post discusses about Debt Funds Taxation in detail
Debt Funds Taxation
Everyone would like to earn more and more income and want to achieve their financial goals in life. With the increase in income, the income tax burden also increases. The higher the income, higher is the tax rate. People want to minimise the tax liability in legal ways so as to have more of their hard earn money in their hand. The government has also given certain ways through which everyone can save tax. Mutual funds also enjoy certain taxation benefits. One can invest in equity mutual fund or debt mutual fund depending upon his or her risk bearing capacity, age, time horizon, financial goal etc. In this post we will have a look at debt funds taxation.
Let us understand more about taxation of the debt mutual fund.
How are debt funds taxed
There are various kinds of debt fund namely, Short term, Fixed Monthly Plan, Ultra short-term, liquid and gilt fund. The taxation of all kind of debt funds is similar.
The returns from funds are characterised short term and long term. In case, of debt mutual fund, if a unit of debt mutual fund is held by an investor for more than 36 months from the date of unit purchase, then it is to be considered as long-term capital gain. On the other hand, if units are sold within 36 months from purchase, then it is considered as short term capital gain.
The holding period of 3 years based on which gain or loss classified as the long or short term was introduced in budget 2013-14. Before this, long term was considered if holding of funds for more than 1 year and less than 1 year classified as short-term capital gain. Also in case of long-term capital gain, the
In case, of short-term capital gain, the investor has to pay tax as per the applicable income tax slab. Such gain will be added to total income and accordingly tax limit is ascertained. For example, Mr. X is in the tax slab of 10% and if there is short term capital gain then he has to pay tax @ 10% on such gain.
While in long-term capital gain, the investor has to pay tax @ flat 20% of the gain with the benefit of cost indexation. Which means the absolute gain of investor will reduce by taking into effect the inflation rate. This will eventually reduce the income or gain which is liable for the tax. Previously before the introduction of budget 2013-14, the rate for long-term capital gain was 10%.
Just to sight more focus on and bring more clarity, I am going to explain this with a hypothetical example.
Tax on Short-term capital fund
An investor invested Rs.50,000.00 in debt fund on April 10, 2013, & remain invested till March Feb. 2014. He is in the tax bracket of 10% for Financial Year 2013-14. Suppose Sunil received Rs. 5500.00 as the return from debt fund. This income from debt fund will be added to his salary and will be taxed at 10% rate. So Rs.550 was the amount he had to pay as tax.
Tax on Long-term capital fund
In the above example, had the amount of Rs.1,00,000.00 remained invested from April 10, 2011, to April 26, 2014. The return he earned from such investment was supposed Rs. 29000. Now this gain is considered as long-term capital gain and will be taxed at the rate of 20% with indexation benefit.
Taxation of dividend on debt funds
It is important to note that dividend received from debt fund is tax-free in the hands of a unit holder of the debt fund. On the other side, the company has to pay Dividend Distribution Tax (DDT) before distributing the dividend. It should be noted that such DDT portion comes from NAV of units and hence after declaring dividend the NAV of the fund reduces.
What is considered as redemption
It is very important to note that whenever investor is making transaction wherein units of debt fund goes out from the holding is considered as redemption. So one has to be careful in cases of a switch over from growth option of dividend option or from one plan to another plan or changing plan from systematic withdrawal or transfer. All such transactions are considered as redemption and necessary taxation will be applied.
It is very simple and clear that taxation of mutual funds comes into the picture as and when units of mutual funds are sold. In the case of a debt fund, when units are sold within 3 years from the date of purchase; its gain is considered as short term capital gain and while units are sold after 3 years from purchase date is called long-term capital gain. Investors in the higher tax bracket are advisable to hold the units till 3 years because if the units are sold within 3 years then the tax rate will be applicable which is increase the outlay of tax. On the other hand investors with 10% to 20% tax bracket will not have the significant tax impact. Moreover, the dividend from debt fund is tax-free.
said in What are Index Funds: meaning, advantages, review, Taxation:
Index funds deliver returns more or less equal to the benchmark.
Returns from Index Funds cannot be more than returns of benchmark index. Its always quite less due to tracking error and expense ratio.
While actively managed mutual funds can give higher returns. If yes, which one is better overall, active funds or passive funds?
Its more of a personal choice to go for actively managed funds or index funds.
Like for me, I change my stance from actively managed funds to index funds, slowly over a period of time, by knowing more and more about them.