We wrote recently that Equity funds have seen a massive inflow in August. Thanks to timely tweets by Aashish Sommaiyaa (CEO, Motilal Oswal Mutual Fund) and Dr. Nathan from ET, we investigated further and found that most of the flows were into Arbitrage funds!
Arbitrage funds are an anomaly. They buy stocks, and sell futures. They pocket the difference. There’s a huge tax advantage.
Because the difference between a stock and the future is primarily linked to a risk free rate, they get about that much (6-7% right now) in the difference. This is the same as most liquid funds. But the tax book says that income from liquid funds is taxable – if you get dividend, 30% is deducted as tax before distribution, and if you sell, you pay capital gains taxes. However, any fund that has 65% in stocks, pays no dividend tax and if you sell, you pay no capital gains taxes (if you hold for a year).
That makes arb funds get you low risk returns near the liquid fund rate, but you don’t pay taxes, which is much more attractive – fixed income with low taxes!
Arb funds, because of their nature, are still classified in the broad terminology as “Equity” funds. (You have equity, tax-savers, income funds, liquid funds, balanced funds and so on but no specific AMFI classification for arb-funds).
But as you can see, arb funds don’t really invest in stocks because they love the stocks. They just want to make some arbitrage, or fixed income type of returns from them. The fact that they buy Reliance doesn’t mean they like the stock – they have no risk if Reliance falls or goes up.
In August 2016, we noted that equity funds saw over 6,500 cr. of money coming in. But when we tabulated all the arb funds Assets together, here’s what we found:
The largest arb funds of ICICI, Kotak and Reliance had seen inflows of about 3500 cr. together. And all arb funds saw a whopping 5,400 cr in increase in AUM!
Assets Under Management (AUM) will increase only for two reasons:
Here, these are arb funds returning around 7% a year. So if the AUM was 26,000 cr. then they would have a monthly return of around Rs. 140 cr. (which is how much your “profit” would be). In reality it will be even lower because some of this will be paid out as dividends.
So nearly all of the growth – of Rs. 5400 crores in the month of August – would have been from inflows.
We also saw that these funds are classified as equity funds. And Equity funds saw a total of Rs. 6,500 cr. inflows in August according to AMFI.
Which means: Out of 6,500 cr., nearly 5,400 cr. has come into arb funds, which is not really an equity purchase! Only the remaining 1,100 cr. is actually something that’s gone to buy stocks.
Data can both hide things from you and can also tell you interesting pieces. From a conclusion that we saw the highest investment in equity by retail in over 11 months we must now change to : Retail investors who are the biggest equity investors through Mutual funds, have only invested Rs. 1,100 cr. in equity funds in August – which isn’t really indicative that retail participation is very high.
Note: We expect that this tax loophole will be removed at some point. Arb fund returns, too. have fallen to below 7%, which reduces their attractiveness. This will trigger redemptions in arb funds at some point. We expect that any unwinding from arb funds may disproportionately hurt some F&O stocks, because that’s where all the volume has been sitting.