If you’re looking for mutual funds as a short-term parking option, liquid funds, short-term debt funds and ultra short-term funds are the most obvious choices. But if you’re an investor in the higher tax brackets, these funds can prove quite tax-inefficient. Both their dividends and short-term gains are taxed at very high rates.
Arbitrage funds, which are treated as equity for tax purposes, offer a good alternative.
What is it?
Arbitrage funds are equity mutual funds suitable for short-term investments, say, a year or so. These funds seek to generate returns mainly by exploiting arbitrage opportunities in the market. While many kinds of arbitrage are available, cash-futures arbitrage is generally used by arbitrage funds. As liquidity is important, most of their equity investments tend to be in large-cap liquid stocks, which find a place in the futures and options market.
Quite different from their other equity cousins that tend to hold on to their investments for a longer period, these funds use the price difference in the market between spot and futures to buy and sell simultaneously, thereby capturing the spread as gains. On expiry, the cash and futures price match, thereby leading to positive returns for the investor. As they have an increased rate of buying and selling, these funds tend to have high portfolio churn. They carry lower risk as their returns do not depend on market direction. As a result, they tend to be benchmarked to the liquid fund indices rather than to equities.
