Exploring Alternative Investment Options to Debt Mutual Funds
Debt mutual funds would no longer benefit from long-term tax relief and indexation after the Finance Bill 2023 was enacted. Funds with less than 35% equity exposure will be treated as short-term and taxed at individual tax rates. This major event has forced investors to rebalance their portfolios to better-suited investments.
In this article, we will discuss alternative solutions to these changes in regulations.
The two types of mutual funds that investors can look at as replacements for debt mutual funds are Hybrid Funds and Arbitrage Funds.
Let’s understand them in detail:
Hybrid Funds-The Best of Both Worlds
What are Hybrid Funds?
Hybrid mutual funds, also known as balanced funds, are an investment option that has gained popularity in recent years. As the name suggests, hybrid funds are a blend of different types of investments, majorly including equity and fixed-income securities.
The two types of hybrid funds most suitable as a replacement for debt funds with additional equity risk are balanced advantage funds and equity savings funds.
Why can they be an alternative to Debt Funds?
1. Reasonable Risk: The addition of equity components to the mix makes the fund riskier. These funds keep 60-70% of their corpus in equity but use futures and options to hedge out most of it, leaving their actual equity exposure anywhere from 10-60%. Though the risk is not the same as debt funds, equity does provide slightly higher returns over long periods as seen in the research below. The expense ratio for both long-term debt funds and hybrid funds is similar.
(Source: moneycontrol.com)
2. Taxation: As they qualify as equity investments, they are charged short-term capital gains (less than a year) of 15% and long-term capital gains of 10%. Additionally, long-term capital gains under Rs. 1 lakh do not attract tax. This makes it attractive when compared to debt mutual funds which will be treated as short-term and taxed at individual tax slab rates.
Arbitrage funds- The Financial Chameleons
What are Arbitrage Funds?
Arbitrage funds are low-risk financial instruments that generate returns often comparable to liquid funds. These funds are the masters of exploiting the differences in the prices of securities traded on different markets. Whether it’s the stock market, derivatives, or even currency markets, these funds can adapt to any environment and make money.
How do they generate returns?
With their ability to navigate through the ever-changing market conditions, Arbitrage Funds can switch between various asset classes and make the most of any opportunity that arises.
They can use complex trading strategies like futures and options to hedge their positions, or they can use simple strategies like buying low and selling high.
Comparing Arbitrage Funds with Debt Funds
During rising interest rates, debt funds become an attractive option as they allow investors to lock in higher interest. Arbitrage schemes have a double advantage over their debt equivalents- slightly better returns compared to liquid funds and tax benefits.
Moreover, these funds enjoy an upper hand over debt funds as they are taxed as equity funds. Arbitrage funds benefit tax-wise. If the investment period is more than one year and shorter than three years, equity fund returns are taxed at 10 percent, while debt fund returns are taxed at the investor’s slab rate. Additionally, long-term capital gains under Rs. 1 lakh do not attract tax.
Why is it a good time to look at them as an alternative to debt funds?
Investor withdrawals from arbitrage schemes between June and November 2022 totaled a staggering amount of Rs. 31,000 crores, according to the Association of Mutual Funds in India. But, in the next three months, there was a surplus investment of Rs. 3,000 crore in these schemes.
This transition was brought about because of the following reasons:
1. Increase in Spreads due to increase in Volatility: Arbitrage funds tend to fare well during periods of heightened volatility. It is because arbitrage opportunities go higher during such stages in the market. The price spreads of equity in the cash market and the futures market determine the returns of the fund. Given the increasing global uncertainties, these spreads have improved in recent months leading to increased returns.
2. Rising Interest Rates: Arbitrage funds tend to track money market rates and their returns tend to increase with the increase in rates. As a result, arbitrage funds have begun to perform better as interest rates rise.
Conclusion
Hybrid funds provide a tax-efficient method for long-term investing, while arbitrage funds offer a unique short-term investment opportunity that allows investors to engage in the market without having to bear the brunt of market volatility but to benefit from it. Hence, depending on your investment horizon, you might want to think about investing in an arbitrage fund or a hybrid fund as a substitute for debt mutual funds.
Disclaimer: Above piece is only for information purposes. Please consult a SEBI Registered Investment advisor before taking any investment decision.
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Debt mutual funds would no longer benefit from long-term tax relief and indexation after the Finance Bill 2023 was enacted. Funds with less than 35% equity exposure will be treated as short-term and taxed at individual tax rates. This major event has forced investors to rebalance their portfolios to better-suited investments.
In this article, we will discuss alternative solutions to these changes in regulations.
The two types of mutual funds that investors can look at as replacements for debt mutual funds are Hybrid Funds and Arbitrage Funds.
Let’s understand them in detail:
Hybrid Funds-The Best of Both Worlds
What are Hybrid Funds?
Hybrid mutual funds, also known as balanced funds, are an investment option that has gained popularity in recent years. As the name suggests, hybrid funds are a blend of different types of investments, majorly including equity and fixed-income securities.
The two types of hybrid funds most suitable as a replacement for debt funds with additional equity risk are balanced advantage funds and equity savings funds.
Why can they be an alternative to Debt Funds?
1. Reasonable Risk: The addition of equity components to the mix makes the fund riskier. These funds keep 60-70% of their corpus in equity but use futures and options to hedge out most of it, leaving their actual equity exposure anywhere from 10-60%. Though the risk is not the same as debt funds, equity does provide slightly higher returns over long periods as seen in the research below. The expense ratio for both long-term debt funds and hybrid funds is similar.
(Source: moneycontrol.com)
2. Taxation: As they qualify as equity investments, they are charged short-term capital gains (less than a year) of 15% and long-term capital gains of 10%. Additionally, long-term capital gains under Rs. 1 lakh do not attract tax. This makes it attractive when compared to debt mutual funds which will be treated as short-term and taxed at individual tax slab rates.
Arbitrage funds- The Financial Chameleons
What are Arbitrage Funds?
Arbitrage funds are low-risk financial instruments that generate returns often comparable to liquid funds. These funds are the masters of exploiting the differences in the prices of securities traded on different markets. Whether it’s the stock market, derivatives, or even currency markets, these funds can adapt to any environment and make money.
How do they generate returns?
With their ability to navigate through the ever-changing market conditions, Arbitrage Funds can switch between various asset classes and make the most of any opportunity that arises.
They can use complex trading strategies like futures and options to hedge their positions, or they can use simple strategies like buying low and selling high.
Comparing Arbitrage Funds with Debt Funds
During rising interest rates, debt funds become an attractive option as they allow investors to lock in higher interest. Arbitrage schemes have a double advantage over their debt equivalents- slightly better returns compared to liquid funds and tax benefits.
Moreover, these funds enjoy an upper hand over debt funds as they are taxed as equity funds. Arbitrage funds benefit tax-wise. If the investment period is more than one year and shorter than three years, equity fund returns are taxed at 10 percent, while debt fund returns are taxed at the investor’s slab rate. Additionally, long-term capital gains under Rs. 1 lakh do not attract tax.
Why is it a good time to look at them as an alternative to debt funds?
Investor withdrawals from arbitrage schemes between June and November 2022 totaled a staggering amount of Rs. 31,000 crores, according to the Association of Mutual Funds in India. But, in the next three months, there was a surplus investment of Rs. 3,000 crore in these schemes.
This transition was brought about because of the following reasons:
1. Increase in Spreads due to increase in Volatility: Arbitrage funds tend to fare well during periods of heightened volatility. It is because arbitrage opportunities go higher during such stages in the market. The price spreads of equity in the cash market and the futures market determine the returns of the fund. Given the increasing global uncertainties, these spreads have improved in recent months leading to increased returns.
2. Rising Interest Rates: Arbitrage funds tend to track money market rates and their returns tend to increase with the increase in rates. As a result, arbitrage funds have begun to perform better as interest rates rise.
Conclusion
Hybrid funds provide a tax-efficient method for long-term investing, while arbitrage funds offer a unique short-term investment opportunity that allows investors to engage in the market without having to bear the brunt of market volatility but to benefit from it. Hence, depending on your investment horizon, you might want to think about investing in an arbitrage fund or a hybrid fund as a substitute for debt mutual funds.
Disclaimer: Above piece is only for information purposes. Please consult a SEBI Registered Investment advisor before taking any investment decision.