Arbitrage schemes of domestic mutual funds, hit by sizeable outflows in the past 18 months due to falling returns, have devised a way to work around their investment mandate to boost performance. Fund managers are investing more in money-market instruments to lift returns but are ensuring that the scheme is still eligible to be taxed like equity schemes, a key factor that drew investors to this product in the past.
These schemes, which benefit from the price anomalies between futures and underlying shares, are required to invest at least 65% of their corpus in stocks to gain the tax advantage that equity schemes enjoy over fixed-income products. But, with arbitrage opportunities on the wane in a lacklustre market, investing 65% of the corpus has compressed returns. The situation has resulted in fund managers coming out with an idea to lift returns while ensuring tax status of an equity scheme.
Taxation rules state that a scheme will be taxed similar to an equity product if 65% of its corpus is in stocks on the last day of a month and the first day of the ensuing month.
For instance, an arbitrage scheme needs to invest at least 65% of its fund on July 31 and August 1 to gain the tax advantage of equity products. Equity investments beyond a year are exempt from paying capital gains tax. Capital gains tax on redemption before one year is 15%.
For debt mutual funds, the long-term gain is taxed at 10% without indexation and 20% with indexation.
Some fund managers are investing more than 35% of their corpus in money market instruments for most of the other days of a month and trimming it below this level on the two days.
"Since money market instruments are fetching higher returns, a large portion of the fund corpus is being diverted to these securities for most of the month before the month-end. This arrangement is not illegal," said a chief executive officer with a foreign mutual fund, requesting anonymity.
"This arrangement has helped some arbitrage schemes to slightly lift annual one-year rolling returns of late," a top official with another mid-sized mutual fund.
Money market instruments, which are short-term, are returning over 8.5% annually, while the arbitrage fund category has returned almost 6% in 2010 and roughly 4.5% in 2009.
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