Navigating market volatility and tax efficiency: Understanding income plus arbitrage funds of funds

Economic Times

11-05-2025

In a nation where fixed deposits have long been the cornerstone of conservative investing, India's debt market is evolving, offering sophisticated avenues for investors seeking stability without sacrificing tax efficiency. While the allure of guaranteed returns from traditional debt instruments remains strong, the impact of taxation can significantly erode these gains, especially for those in higher tax brackets. This is where innovative categories like "Income plus Arbitrage Fund of Funds" are gaining prominence, presenting an alternative that blends the relative safety of debt with a more favourable tax treatment, particularly for those with a medium-term investment horizon. Let's delve deeper into this category, its advantages, and how it can uniquely benefit investors.
ADVERTISEMENT An Income plus arbitrage Fund of Funds (FoF) is a unique mutual fund category that strategically invests in a mix of underlying debt-oriented schemes (up to 65%) and arbitrage schemes (the remaining portion). This blend aims to provide the stability associated with debt investments while leveraging the opportunities presented by arbitrage strategies.
From a taxation perspective, mutual funds in India are broadly categorized based on their equity exposure. According to the Finance (No. 2) Act 2024, if an Income plus Arbitrage FoF allocates between 35% and 65% of its portfolio to arbitrage funds (which are treated as equity for taxation purposes), it falls under the "Non-Specified Mutual Fund" category.
This classification brings a significant advantage: tax efficiency. For investors holding units of such funds for at least two years, the gains are taxed at a lower rate of 12.5% (plus applicable surcharge and cess) after indexation benefits. This can be notably more favourable compared to the taxation of traditional debt mutual funds, where gains are taxed as short-term capital gains as per the investor's income tax slab, irrespective of period of holding.The core strength of the Income plus arbitrage FoF category lies in its ability to offer a compelling combination of stability and tax efficiency: Stability in Volatile Markets: By allocating a significant portion to debt instruments and employing arbitrage strategies, these funds tend to exhibit lower volatility compared to pure equity funds. Arbitrage strategies, which capitalize on price discrepancies of the same asset across different markets, are generally less sensitive to broad market movements. This makes the category particularly attractive during periods of market uncertainty. Equity-like Taxation: The taxation framework allows investors to potentially enjoy returns that are taxed more favourably than traditional debt funds, provided they maintain a holding period of at least two years. This makes it an optimal solution for investors seeking a more tax-efficient alternative to pure debt funds without taking on excessive equity risk. The Income plus Arbitrage FoF category can offer distinct advantages for a specific set of investors:
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Risk-Averse Investors Seeking Better Tax Efficiency: Individuals who prioritize capital preservation and seek relatively stable returns, but are also mindful of tax implications, can find this category appealing. It offers a middle ground between the potentially higher volatility of equity funds and the less tax-efficient nature of traditional debt funds.
Individuals who prioritize capital preservation and seek relatively stable returns, but are also mindful of tax implications, can find this category appealing. It offers a middle ground between the potentially higher volatility of equity funds and the less tax-efficient nature of traditional debt funds. Medium-Term Investors: The tax benefits are most pronounced for investors with a holding period of two years or more. This category is well-suited for those with a medium-term financial goal, such as funding a significant purchase or building a stable corpus over a few years.
The tax benefits are most pronounced for investors with a holding period of two years or more. This category is well-suited for those with a medium-term financial goal, such as funding a significant purchase or building a stable corpus over a few years. Investors in Higher Tax Brackets: The lower tax rate on long-term capital gains (after two years) can be particularly beneficial for individuals in higher income tax brackets, as it may significantly reduce their tax liability compared to investing in traditional debt instruments. The Income plus Arbitrage Fund of Funds category presents a unique investment proposition by blending the stability of debt with the tax efficiency associated with equity-linked taxation. By strategically allocating to debt and arbitrage opportunities, these funds aim to navigate market volatility while providing investors with potentially better post-tax returns over a medium-term horizon. For investors seeking a stable and tax-efficient investment avenue, this category warrants careful consideration as part of a well-diversified portfolio. Source: Axis MF Research as on 4th May 2025
(The author Devang Shah is Head – Fixed Income, Axis Mutual Fund. Views are own)
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(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)