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Best arbitrage mutual funds to invest in 2019

Arbitrage mutual fund schemes still retain some edge over debt mutual funds.

ET Online|
Updated: Nov 08, 2019, 04.18 PM IST
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Here's a monthly update on our recommended arbitrage mutual funds. Once again, there are no changes in our recommendations this month. Mutual fund advisors believe that these schemes can provide better returns with less volatility.

Arbitrage schemes were earlier treated as equity schemes for the purpose of taxation. This means, they used to enjoy zero tax on long-term capital gains earlier. This tax advantage made them the favourite of mutual funds investors, especially those with huge amounts to park for a short period. However, after the re-introduction of long term capital gains on equity mutual funds, arbitrage funds lost its tax-free LTCG status.

However, arbitrage mutual fund schemes still retain some edge over debt mutual funds, say mutual fund advisors. Short-term capital gain made on debt investments held for less than three years are added to the income and taxed according to the income tax slab applicable to investor. Also, investments in debt mutual funds qualify for long-term capital gains tax only if held over three years. Long term capital gains on debt mutual funds are taxed at 20 per cent with indexation benefit. The indexation benefit allows investors to inflate the cost of purchase and it helps to reduce the total tax outgo.

As said earlier, arbitrage funds enjoy better taxation because of they are taxed like equity mutual funds for the purpose of taxation. Long term capital gains on investments held over a year in arbitrage funds are taxed at 10 per cent. Short-term capital gains made on arbitrage mutual fund investments held for less than a year are taxed at 15 per cent. This favourable taxation still gives arbitrage funds an edge over debt mutual funds. Investors, especially those in the higher income tax bracket, can use them to park money for short period.

If you are new to mutual funds, here is how arbitrage funds work. These mutual fund schemes look to exploit the arbitrage opportunities available between the cash and the future market. Essentially, these schemes look for the price difference between the spot market and derivatives market to earn risk-free returns. The price mismatching would be more in a volatile market. So, volatility works in favour of arbitrage mutual fund schemes.

Arbitrage mutual fund schemes are expected to offer marginally higher post-tax returns than debt mutual funds. However, this will not be the case always. For example, the arbitrage fund category is offering around 5.90 per cent in the last on year.

"If you have an investment horizon of nine months to a year, you can invest in arbitrage funds for lower volatility," says Deepali Sen, Founder, Surjan Financial Advisors. "if you want okay returns with lower volatility, you should go for arbitrage funds," she adds.

Here are our recommended arbitrage mutual fund schemes you may consider to invest:
Kotak Equity Arbitrage Fund
Reliance Arbitrage Fund

Methodology:
If you are interested in the methodology employed to shortlist these schemes, you may read:
ET.com Mutual Funds has employed the following parameters for shortlisting the Hybrid mutual fund schemes.
1. Mean rolling returns: Rolled daily for the last three years.
2. Consistency in the last three years: Hurst Exponent, H is used for computing the consistency of a fund. The H exponent is a measure of randomness of NAV series of a fund. Funds with high H tend to exhibit low volatility compared to funds with low H.
i) When H equals 0.5, the series of return is said to be a geometric Brownian time series. These type of time series is difficult to forecast.
ii) When H is less than 0.5, the series is said to be mean reverting.
iii) When H is greater than 0.5, the series is said to be persistent. The larger the value of H, the stronger is the trend of the series
3. Downside risk: We have considered only the negative returns given by the mutual fund scheme for this measure.
X = Returns below zero
Y = Sum of all squares of X
Z = Y/number of days taken for computing the ratio
Downside risk = Square root of Z
4. Outperformance
i) Equity portion: It is measured by Jensen's Alpha for the last three years. Jensen's Alpha shows the risk-adjusted return generated by a mutual fund scheme relative to the expected market return predicted by the Capital Asset Pricing Model (CAPM). Higher Alpha indicates that the portfolio performance has outstripped the returns predicted by the market.
Average returns generated by the MF Scheme =
[Risk Free Rate + Beta of the MF Scheme * {(Average return of the index - Risk Free Rate}
ii) Debt portion: Fund Return – Benchmark return. Rolling returns rolled daily is used for computing the return of the fund and the benchmark and subsequently the Active return of the fund.
5. Asset size: For Hybrid funds, the threshold asset size is Rs 50 crore


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