[whitewing]

NPS tier 2 seems to be an under appreciated mode of a debt portfolio.
We can choose the % holding between corporate, and Govt debt holdings. I think we can tweak the allocation twice a year.
The debt part (corporate+govt debt) have given a >9% return over the past decade or so.

[Eco_boost]

So i recently started investing in a few debt funds, and have been getting surprisingly good returns.
1- Tata Money Market fund is delivering around 7.5% annual returns.
2- SBI Magnum Gilt Fund, is slightly more volatile than money markets, but is delivering between 11-13% annually.
Both these funds are way better than FD’s and way safer than equities.

[DigitalOne]

Originally Posted by Eco_boost

2- SBI Magnum Gilt Fund, is slightly more volatile than money markets, but is delivering between 11-13% annually.

Please be aware that Gilt Funds give good returns when the interest rates are reducing (or expected to reduce) in the near future (<2 years). This is the economic scenario in India, US, and many other parts of the world now. That's why you are seeing good returns from Gilt funds recently.

Conversely, when interest rates are increasing the returns will be very low or could be negative also.

So, for Gilt funds timing is key.

[kap04]

Are arbitrage funds the sensible option to move some of the fixed deposits to now? Or are there any better options? I would be keeping an amount in FD because of the guaranteed returns, but want to move the rest of the amount, as we end up paying quite a lot of tax every year on FD.

[SmartCat]

Originally Posted by kap04

Are arbitrage funds the sensible option to move some of the fixed deposits to now? Or are there any better options? I would be keeping an amount in FD because of the guaranteed returns, but want to move the rest of the amount, as we end up paying quite a lot of tax every year on FD.

Any debt fund is better than Fixed Deposits, because taxes are 'deferred'. Unlike FDs, you pay tax only when you sell units in debt funds.

Also, when you sell debt fund units, it is unlikely that you will need all the money in the debt MF portfolio. If you pull out Rs. 5 Lakhs out of your Rs. 20 Lakhs in debt funds, you pay taxes only on the gains made on that Rs. 5 Lakhs. The remaining Rs. 15 Lakhs will continue to compound, till you redeem them.

Arbitrage funds offer liquid fund-like returns, but is treated as an equity fund for taxation purposes. So arbitrage funds offer tax advantage over debt funds. However, don't put too much money in arbitrage funds. Under certain very rare circumstances (black swan event), arbitrage funds can lose capital.

[Linuskm]

Originally Posted by Eco_boost

So i recently started investing in a few debt funds, and have been getting surprisingly good returns.
1- Tata Money Market fund is delivering around 7.5% annual returns.
2- SBI Magnum Gilt Fund, is slightly more volatile than money markets, but is delivering between 11-13% annually.
Both these funds are way better than FD’s and way safer than equities.

Are gilt funds having any min lock in period like 5 years etc ? How are these treated from taxation point ? Pls share

[shipnil]

Originally Posted by SmartCat

Arbitrage funds offer liquid fund-like returns, but is treated as an equity fund for taxation purposes. .

Previously, till about 5 years ago, I used to park funds in liquid fund. But after the change in tax treatment, I moved all future investments (surplus cash earmarked for short term) in arbitrage funds. I didnot think of black swan events. So if you have to recommend, what split would you recommend between debt and arbitrage?

[SmartCat]

Originally Posted by shipnil

But after the change in tax treatment, I moved all future investments (surplus cash earmarked for short term) in arbitrage funds. I didnot think of black swan events. So if you have to recommend, what split would you recommend between debt and arbitrage?

Take a call after arming yourself with knowledge about this black swan event, that will put capital in your arbitrage funds at risk. The fund buys stocks and sells futures to earn 7% to 8% pa returns. So the risk comes from usage of derivatives in the mutual funds.

Black swan risk example:

Let's assume that India gets into a serious war with China, due to which stock markets are shut for 30 days. But futures contracts have an "expiry" and vanish from the arbitrage fund portfolio end of the month. But the stocks remain in the fund. So when the stock market re-opens, your arbitrage fund is transformed into a pure equity fund, and exposed to same risks as an equity fund. In panic, if the fund manager exits the stocks, any losses become permanent.

If you did not understand the above, that's fine. Just keep in mind the risk/probability of Indian stock market shutting down for an extended period of time. For eg: US stock markets shutdown for 4 days after Sept 11 attacks. Pakistan stock market shutdown for a couple of months because of Covid crash. There are many such examples if you look around.

Now you decide what percentage you want to keep in arbitrage funds.

[Naetik30]

Originally Posted by SmartCat

Now you decide what percentage you want to keep in arbitrage funds.

Great explanation @SmartCat. Thanks for that.
I am very new to Arbitrage funds. For discussion, lets say there is a stock market shutdown for 1 month due to a black swan event. In general, what % of an arbitrage fund's portfolio would be affected. In other words, what % of a fund's contracts may have expired in that 1 month that would get affected.

Or am I analysing this wrong?

[SmartCat]

Originally Posted by Naetik30

For discussion, lets say there is a stock market shutdown for 1 month due to a black swan event. In general, what % of an arbitrage fund's portfolio would be affected. In other words, what % of a fund's contracts may have expired in that 1 month that would get affected. Or am I analysing this wrong?

It doesn't even have to be 1 month closure! Even 3 day stock market closure close to the end of the month will result in arbitrage going haywire. An arbitrage fund might buy a stock like HDFCBANK and sell futures in all three Aug/Sept/Oct contracts. All these contracts expire on last thursday of the respective month.



So hypothetically, if stock market is shut on 27th Sept 2024 and re-opens on 1st Oct 2024, your portfolio might see equity fund like losses, if markets re-open with a gapdown move. An equity fund might recover losses, but arbitrage fund will make such losses permanent. The fund manager will typically exit stock positions in such situations, because holding just equities and hoping the price will recover is beyond the scope of these funds

[Naetik30]

Originally Posted by SmartCat

It doesn't even have to be 1 month closure! Even 3 day stock market closure close to the end of the month will result in arbitrage going haywire.

Thanks a lot. Another question if you dont mind.

I read that arbitrage funds can only make money when the stock goes up. Why cant they make money when stock goes down? Or in other words are they restricted from short selling?

[SmartCat]

Originally Posted by Naetik30

I read that arbitrage funds can only make money when the stock goes up. Why cant they make money when stock goes down? Or in other words are they restricted from short selling?

Looks like there is wrong information floating around about arbitrage funds. They make money if a stock goes up, goes down or stays where it is! That's why arbitrage funds give a steady 7% to 8% per annum, despite having a portfolio that looks like this (eg: Kotak Arbitrage Fund)



Let me explain how Arbitrage funds make money (ignore or ask questions if something seems confusing or complicated ). Let's go back to HDFC BANK example:



If an arbitrage fund buys HDFC Bank now for Rs. 1,614 and sell HDFCBANK SEPT FUT for Rs. 1,627, the profit on this trade is Rs.(1627 - 1614) = Rs. 13 per share. That's because over the duration of contract (45 days), spot price and futures price converge. Whether the stock moves up or down, does not matter.



So if the fund buys 1,000 shares of HDFCBANK, they make a profit of Rs. 13,000 on that investment guaranteed. This works out to be 0.8% returns over a period of 45 days (today is Aug 16th, contract expires on end of sept)

Expanding on the above:

Investment = 1000 shares x Rs. 1614 per share = Rs. 16.14 Lakhs
Profit per share = Rs. 13
Total profit on the trade = 1000 shares x Rs. 13 = Rs. 13,000
RoI = Rs. 13k divided by Rs. 16 Lakhs = 0.8%
Trade duration = 45 days

Annualized returns = 0.8% x 365/45 = 6.5% pa

So the fund manager's job is to find stocks with the widest difference between spot and futures prices. Not whether a stock will go up or down. Do note that anybody with a brokerage account can do this on their own. But returns will not be commensurate to the efforts put in.

[DigitalOne]

Originally Posted by SmartCat

!That's why arbitrage funds give a steady 7% to 8% per annum, ...

Annualized returns = 0.8% x 365/45 = 6.5% pa

....

So the fund manager's job is to find stocks with the widest difference between spot and futures prices.

Well explained. Just a couple of things to add. The funds are typically invested in liquid instruments till opportunity occurs where the projected arbitrage return is greater than liquid instruments' return. As every funds is hunting for the same opportunities, it becomes scarce and thus arbitrage fund returns converge to liquid fund returns. The only plus of arbitrage funds is the favourable tax treatment.

[wocanak]

Originally Posted by shipnil

So if you have to recommend, what split would you recommend between debt and arbitrage?

If you are okay with a bit more equity risk, then you can go for equity savings fund, which invest ~33% in equity 33% in arbitrage and the rest in debt. They ensure equity+arbitrage is > 66% and hence it qualifies as equity fund for taxation. If you are not comfortable with the increased exposure to equity, you can shift some investment from equity funds to equity savings to ensure the desired amount of arbitrage+debt is met. This will give you a 50:50 split with equity like taxation.

There maybe balanced/conservative hybrid funds with mandate to investment > 66% in arbitrage and rest in debt, that will give you a 2:1 split between arbitrage and debt with equity like taxation.

If you split and invest directly in debt funds, then that portion will get debt taxation.

[anandhsub]

Originally Posted by SmartCat

But futures contracts have an "expiry" and vanish from the arbitrage fund portfolio end of the month. But the stocks remain in the fund.

I dont think arb funds roll that close to expiry. In any case without a settlement price it is not possible for futures to expire. So I believe the last day for futures will be extended in that case. Has happened for a few US interest rate futures.

However is there a taxation risk? Is it possible the current Govt can bring a draconian law where mutual funds also need to pay tax on profits on their futures positions as Government considers that "speculative" trading which will kill this class of funds.

Also "arbitrage" is a misnomer for what these funds do. Should just call them "carry" funds.