Why Post-Tax Yield of Arbitrage Funds is Better than Bank Fixed Deposits (FDs)

In the realm of personal finance, safety and returns often play a tug of war in the minds of investors. Traditionally, Bank Fixed Deposits (FDs) have been the go-to investment option for those seeking safety and assured returns. However, in recent years, Arbitrage Funds have emerged as a compelling alternative, particularly when considering post-tax yields. This article explores why the post-tax yield of Arbitrage Funds tends to outshine that of Bank FDs.

Understanding the Basics

Bank Fixed Deposits (FDs):
FDs are a simple, risk-free investment where you deposit a lump sum with a bank for a fixed tenure at a predetermined interest rate. The interest earned is taxable as per your income slab.

Arbitrage Funds:
Arbitrage Funds are a type of mutual fund that capitalizes on price differentials between the cash and derivatives markets. These funds buy stocks in the cash market and simultaneously sell them in the futures market, earning the spread as profit. They are considered low-risk because they hedge against market volatility.

Taxation: The Deciding Factor

One of the most significant advantages of Arbitrage Funds over Bank FDs lies in the taxation treatment.

Taxation on Bank FDs:

• The interest earned on FDs is added to your income and taxed as per your income tax slab. For someone in the highest tax bracket (30% plus cess and surcharges), this can significantly reduce the effective yield.
• No matter the tenure, FD interest is taxed every year, reducing the compounding effect.

Taxation on Arbitrage Funds:

• Arbitrage Funds are taxed like equity funds. If held for more than 12 months, gains are classified as long-term capital gains (LTCG) and are taxed at 12.5% (without indexation benefits) if the gains exceed ₹1.25 lakh in a financial year.
• Short-term capital gains (STCG) for holdings of less than 12 months are taxed at 20%, still lower than the highest income tax slab applicable to FD interest.
• Moreover, the taxation occurs only when you redeem the units, which allows for the compounding of returns without annual tax deductions.

The Impact of Tax Efficiency on Post-Tax Returns

Let’s consider an example to illustrate the difference in post-tax returns between an FD and an Arbitrage Fund:

• Scenario 1: Bank FD

  • Investment: ₹1,00,000
  • Interest Rate: 6%
  • Tenure: 3 years
  • Tax Slab: 30%

  Calculation:

  • Interest Earned: ₹18,000 (₹6,000 per year)
  • Tax on Interest: ₹5,400 (30% of ₹18,000)
  • Post-Tax Interest: ₹12,600

  Effective Post-Tax Yield: 4.2% per annum

• Scenario 2: Arbitrage Fund

  • Investment: ₹1,00,000
  • Expected Annual Return: 5.5% (conservative estimate)
  • Tenure: 3 years

  Calculation:

  • Gain after 3 years: ₹17,352 (compounded annually)
  • LTCG Tax: ₹919 (12.5% of ₹7,352 assuming gains above ₹1.25 lakh are taxed)

  Post-Tax Return: ₹16,433

  Effective Post-Tax Yield: 5.25% per annum

As the example demonstrates, despite the lower nominal return, the Arbitrage Fund provides a higher post-tax yield due to more favorable tax treatment.

Other Benefits of Arbitrage Funds

1. Liquidity: Arbitrage Funds generally offer better liquidity compared to FDs. While premature withdrawals from FDs attract penalties, you can redeem Arbitrage Fund units at any time without such penalties, although exit loads may apply if redeemed within a specific period.

2. Risk and Return Balance: While FDs are considered risk-free, Arbitrage Funds, though not entirely without risk, are relatively low-risk and can sometimes outperform FDs, especially in a stable or volatile market.

3. Inflation Hedge: FDs often struggle to keep pace with inflation, especially after taxes. On the other hand, Arbitrage Funds, being linked to market performance, have the potential to offer returns that outpace inflation over the long term.

Conclusion

While Bank FDs remain a popular choice for risk-averse investors, the tax efficiency and potential for better post-tax returns make Arbitrage Funds a compelling alternative, particularly for those in higher tax brackets. By balancing risk with the potential for better returns, Arbitrage Funds can serve as a valuable component of a diversified investment portfolio, especially for those looking to optimize their post-tax income.