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Tax Arbitrage Using Arb-Funds To Be Removed?

Value research says it’s likely that in the budget, Arbitrage funds will be considered debt funds for the sake of tax.

After the last budget (July 2014) you had to hold “debt” mutual funds for three years before they were considered long term. Equity funds, however, were tax-free after a year. A special species of such funds, called “Arbitrage funds” came into demand.

India loves the concept of fixed income, but hates the concept of tax. While you could get returns of 9% in debt funds, the post tax return fell to under 7% for the richest. Arbitrage funds would provide, in all probability, about 8% – a tad lower than the short term debt fund – but the returns weren’t taxed.

Debt funds, if held for a year, were earlier held to have long term capital gains taxes. Here, you could subtract inflation and pay tax only on what was extra. In a high inflation era, this meant that 9% was nearly tax free, with inflation running at around 9% anyhow.

But the 2014 budget changed that, with debt funds needing to be held for 3 years before subtracting inflation. That means your 9% was effectively taxed as income, at your highest tax slab.

People moved to equity arbitrage funds. These funds bought stocks and simultaneously sold futures, pocketing the difference. This provided opportunities of around 8-9% per year, and arb funds came into demand. So much so that a single fund (from JM) is supposed to have received a whopping Rs. 5000 cr. as fresh investment last year after the budget.

And if what Value Research is saying is true, this thing collapses like a ton of bricks. Since investors bought after the last budget (July 2014) and the next budget is now (Feb 2015) they can’t even exit easy. If they exit after the budget but before March 31, it wouldn’t be a year after they got in, so short term capital gains taxes will apply. If they exit after April 1, the new budget will come into play and they have to wait three years.

Impact on Equities

Given that it’s arbitrage, the impact on equity markets will be strange. If you have, as Value Research shows, about 10,000 cr. in such funds. If money leaves, then many such funds will have to exit their arb positions. Exiting arb positions will typically involve getting out of the cash and future position at the same time. While this should be cash neutral, the typical arb structure involves

  • Buying in the cash market once
  • Selling future this month
  • at the end of the month, “rolling over” the future position (buying back this month’s future, and selling next months)

This means the stock is only bought once and the future rolled over as long as AUM is increasing.

When AUM decreases they have to unwind the entire position. The equity position has to be sold and now.

So the impact is when they have to sell a heavy equity position, the unwinding in the cash market could cause jitters. Watch out for this unintended but interesting move if what VR says comes true: that arb funds will be treated as debt funds.


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  • Manoj Nagpal says:

    The figures do not bear out the facts that you have mentioned.
    There is hardly any shift to Arbitrage Funds. The total assets under Arbitrage funds across all mutual funds is even now less than Rs. 10,000 cr. This is not a large kitty considering that liquid funds and ultra short term funds are much larger leave alone comparing them to Fixed Deposits
    Secondly, agree there has been a increase in assets of Arbitrage Funds. However this increase was driven by bonus stripping rather than the lure of post tax returns. One single fund had collected around Rs. 5700 cr in its bonus strip and now that same fund is still the largest at around Rs. 3300 cr after declaring its bonus. So it did around Rs. 2500 cr in a week and that unwinding happened pretty smoothly
    Hence there may not be any massive unwinding even if the taxation changes.

    • Good point. But let’s look at JM’s case. JM’s arb fund on Jun 30 had 90 cr. in AUM. In Jan end it has over 3,300 cr.
      The fund has about 200 cr. in investments and CBLO that it may be able to use for redemptions. But if redemptions are heavy, then it will have to liquidate.
      Take its largest position: HDFC Bank. That has about 150 cr. stock, 150 cr. futures. It trades about Rs. 180 cr. per day or so in cash. (It trades about 700 cr. in futures per day)
      Now the fact that the arb fund went from AUM of 90 cr. pre-budget to some 3,300 cr (sure, it went even higher to about 4200 cr. and came back down). The bonus was in November of 4:10, so you got 4 shares for every 10. To bonus strip you would have sold 10, and kept four, or such (why else would you strip bonus?) Now that means nearly 10/14 of the AUM should have left, if it was only bonus stripping. That means out of the 4200 cr, about 3,000 cr. should have been sold.
      But no, AUM came down only by 1200 cr. So my take is that it wasn’t all bonus stripping, a good portion was for investing in some kind of fixed income return.
      However, if the FM makes it a debt fund two things happen:
      a) people who invested for tax free in a year will now have to wait three years, and the fact is that the return isn’t better than a short term debt fund so they exit
      b) bonus share folks will again exit because selling after a year, the original bonus stripping plan, will no longer be tax free (profits charged to 20% tax)
      Let’s say the AUM selling happens fast and it goes down to 1000 cr. That’s 2,000 cr. sold. To get this, the fund has to unwind positions in its top portfolio. Let’s say it ends up having to sell about 30% of it’s HDFC bank position, which would mean 54 cr. Now selling 54 cr. of HDFC bank will typically take it about a week or so if it doesn’t want to get a horrible price (if you are more than 5% of the volume of any stock, you’re going to have a tough time getting a decent price).
      And consider that even the next two big arb funds (IDFC and Kotak) have > 100 cr. in HDFC Bank each. When all of them unwind, things get a little zany in the market….

      • Manoj Nagpal says:

        Yes you are partly correct. But some more facts just for your information
        1. JM Arb Fund did the bonus strip collection before the Budget i.e. before July 10th/11th
        2. Bonus collection was Rs. 5500 cr. So if you look at the AUM of July end it was 5700 cr
        3. As of Nov end the AUM was Rs. 5900 cr. So b/w July end till Nov end AUM growth is only Rs. 200 cr i.e. 3.5% which isco-incidentally equal to the NAV appreciation. So almost no new flows came b/w July end to Nov end.
        4. So as per this all savvy investor’s shifted their AUM immediately during budget month and after that there is again no interest in so called tax free returns of JM arbitrage fund. I find it strange that interest again died down. The only logical explanation I feel is that all money is for bonus strip
        5. As of Dec end the AUM is Rs. 3300 cr. So net outflow is Rs. 2600 cr in one month and not 1200 cr as you say.
        6. Your calculation that there was a 4:10 bonus on Nov 27th and hence there should be a huge 10/14 drop in AUM is logical. But what if there was another bonus which was silently done under wraps. Oh come on, don’t build a conspiracy theory – you would tell me.
        7. Well on Nov 27th, the NAV of bonus option re-adjusted from 18.74 to 13.39 due to the 4:10 bonus. Rightly so
        8. Then, unnoticed by many, on 18th Dec the NAV again adjusted from 13.44 to 10.24, if you have missed that. Yes Sir, another 33:100 bonus was declared
        9. So effectively now if you re-work your numbers with this additional piece of info, all this will add up to the exact outflow of Rs. 2600 cr and lead you to the same conclusion that all money was for bonus strip
        10. And you would also appreciate that 2600 cr outflow from the fund in 10-12 days i.e. from 18th Dec to Dec 31st did not create any zaniness in the market. Obviously I assume these smart investor’s only moved out after the second bonus on 18th Dec.
        I am not trying to say that there is no advantage in the tax free returns. And the industry has seen some incremental flows in arbitrage funds, but I believe that it is nothing to write about.
        Not quibbling, just putting the data on the table.

        • Very cool, thanks. Responding.
          1) See this link: (click here) It shows you JM Arb advantage fund has an AAUM of 4168 cr. for July to Sep. On Jun 30 it was like 200 cr.
          2) July end AUM was 5669 cr. (see here)
          3) Just saying its probably likely that the fund got inflows after the budget also, and because of the fact that the budget screwed debt fund investors.
          4) They announced the bonus on Nov 27, so technically the window to invest was available about 3 months earlier (i.e. till Aug 27) so it’s likely they spread inflows all of July?
          5) Okay let’s assume all inflows were for bonus stripping, the base argument still applies. I’ll get to that.
          6) Btw, that “second bonus” is a bloody killer find! Can I write about it?
          7) When the second investment happened it was likely to be known that people would exit, so the fund must have kept appropriate balances? This is why the market didn’t correct – the money was harvested by culling positions between Dec 1 and Dec 18. They knew exactly how much would move out so they could easily get out over a longer time instead of immediately.
          8) Maybe I’m getting into conspiracy theories but look closely at Nifty and HDFC bank and the big stocks between Dec 1 and Dec 18 exactly. The Nifty fell from 8600 to 7900. Maybe it was coincidence, or maybe not…
          9) And this was one fund, just 2600 cr. We have more AUM now in arb funds, about 10,000 cr.
          10) And here’s the clincher. What happens if the FM announces this? Assume all traffic was only for bonus stripping. The funda of bonus stripping is:
          a) buy now
          b) get bonus units
          c) sell original inv now at loss to offset against other STCG
          d) sell bonus units after one year to get no long term capital gain because arb funds are equity funds
          Wait, is d) still valid if FM changes arb fund to debt fund instead of equity?
          11) NO, it’s not. So even if they sell after a year, they will have debt fund taxation. Units bought at zero (bonus) so tax = full value at highest slab since sold within one year.
          12) What if they wait three years? Still, 20% tax because you cannot inflation index zero. technically they get no tax saving at all.
          What do you think?

        • Manoj Nagpal says:

          Oops, sorry for this. But I will have to counter again
          1. The closure of the bonus strip window was July 7th. That it got hyped up in the media, hence he just delayed it. So all money came in by July 7th. I know, but you will have to take my word for it.
          2. Agree July end AUM was Rs. 5669 cr and I said 5700 cr. My bad – but you are quibbling here 🙂
          3. Second bonus is a reality. If you still doubt me – you can put the blame on me when you write about it.
          4. I agree he had time to plan for the outflow so that would help and it is not a sudden outflow.
          5. Since you know where to find the portfolios, not sending links. Nov 30th HDFC Bank holding in the fund was Rs. 156 cr. And Dec end HDFC Bank is at 148 cr. He didn’t sell it!! So your hypothesis of HDFC Bank and Nifty falling just doesn’t add up
          6. Arb funds AUM maybe 10,000 cr but most guys just keep around 65%-70% in equity arbitrage, rest is in debt. You know they get equity tax treatment even then. So effective positions are much lesser.
          7. Lastly will the FM take off the benefit – I think he will – but not because of the tax free returns for genuine investors but because of these bonus strippers. Ideally he should just take away just the facility of bonus/dividend stripping in mutual funds. Last year bonus strippers in debt funds got stuck this year maybe it will arbitragers.

        • 2. Not quibbling, just saying AAUM was 4200 cr for the qtr, and 5700 cr. end of month, so it doesn’t really make sense if it were to be in by the 7th of the month no? But tell you what – let’s ditch that part, we both probably agree that regardless of why the money came in, the FM changing the arb funds to debt will hurt the buyer (bonus stripper, or debt replacement).
          3. I realize second bonus is a reality – that’s why I wanted to write! No blame, it’s a great find!
          5. I did a full analysis on both Nov end and Dec end. (Can send you excel). He didn’t sell much of HDFC (which btw didn’t fall as much, but the Nifty did). But he sold 84 cr. of IDFC, 100 cr. Tata Steel, 55 cr. tata motors, 90+ cr TCS and ICICI Bank and NTPC and 76 cr. ITC.
          Of all of them only ITC seems to have lifted up – rest all were down, some down big in the first 18 days of Dec. The hypothesis may not altogether be true, but having 5-10 cr. of volumes per day of selling had probably impacted, one would think. Plus this is likely to have been staggered over days, so a 100 cr. on Tatamotors would have taken time – it fell from 532 to 472 in those 18 days, and each day volumes were around 200 cr. There were 12-13 trading days. So they probably did 8-10 cr. per day of sales, which was around 4% to 5% of the day’s turnover. Not saying this is primarily responsible for a fall, but as a trader I’ve seen that even a 2% position can be a huge mover for a stock, and this is a larger position, probably front run, probably known well (as in about the quantities that were going to be sold). Again, this is conspiracy theory to assume these sales pushed the markets down, but it does make sense that 2,000 cr. worth sales in 12 days affected the market.
          I cross checked SEBI’s data. Mutual funds had gross sales of 10,700 cr. in Dec 1 to Dec 18. JM’s sales alone were 2000 cr. (These are gross not net, but I see JM’s a pretty big part)
          6. Yes arb funds do about 70% stock only, and some FDs are required to maintain margins for the futures, because I think many brokers aren’t doing proper cross margining yet (plus you need payouts for futures) Even as of end Dec we see 900 cr. in FDs, and 200 cr. in money market+CBLO out of 3300 c.
          7. I think we are both agreed on this – that FM will likely take off the benefit. What we disagree on is whether it will hurt the market.
          My belief is that unlike in a planned bonus where you get time to exit appropriately, a change in the tax rule will cause a run on arb funds which will need to liquidate fast to pay T+2. To the extent payouts can be met with cash, it will be. Beyond that, they’ll have to sell. And I hope I’m wrong but it looks like the market impact will be present. (but then, these are budget times, and you really don’t know it may be some other measure that hurts even more!)

  • Obu says:

    Guys, Thats a lot of info in the comments for readers. Could you mention where I can check the overall AUM under arbitrage funds, so that when budget announcement happens, I can see the rate of decreae in AUM to benefit out of this special situation. Many thanks.

    • It’s 10,000 cr. in arb funds afaik. Go to value research online and click on funds and then category, Hybrid/Arbitrage…

      • Obu says:

        Thanks much Deepak. The total net assets as of Jan 31st are about INR12120Cr. Hdfc Bank, Lupin are the stocks where most positions taken followed by HDFC, Reliance, IDFC. Overall financials/bank nifty should drop in March if the hypothesis is correct. They do hold around 30% in debt. And there is no real time monitor on asset size which are updated monthly. So if these stocks fall rapidly, we can only think this as one of the reasons.