INVESTMENT: Smart options to park short-term money

Investors meticulously plan their medium- and long-term investments, but short-term investments do not get the attention they deserve. This gets corroborated by the fact that savings bank account and short-term FDs remain the preferred options to park short-term money. Most investors do it to avoid any volatility and maintain liquidity at all times. While the reasons are perfectly valid, investors must realise that there are options with the potential to offer higher returns and that without compromising much on these important parameters.

To begin with, there are liquid funds, ultra-short duration and low duration debt funds that are ideal for a time horizon of up to three, six and 12 months respectively. For a slightly longer time horizon, there are short-term income funds. One has to contend with some amount of volatility and certain risks like interest rate, default and liquidity risks. However, a careful selection of funds can mitigate risks to a large extent.

Arbitrage funds, too, haven’t caught the attention of investors, despite being an effective and tax-efficient option. An arbitrage fund is an equity-oriented scheme which seeks to generate income through arbitrage opportunities emerging out of mis-pricing between the cash market and the derivates market.

For example, a fund manager of an arbitrage fund may buy a stock ‘A’ at Rs 100 and sell its future at Rs 105. As a result he would lock a return of Rs 5 at the time of initiation of the trade. By the end of the expiry, their prices would generally converge to Rs 110. On unwinding the position, that is, by selling stock and buying future, the profit earned on the stock would be Rs 10, whereas the loss from the future market would be Rs 5. Therefore, the net profit from the transaction would be Rs 5.

As is evident, the fund manager is usually able to make money for investors regardless of the market movements. However, the ability of these funds to generate higher returns depends on the volatility in equity markets. While arbitrage funds have the potential to provide healthy returns, there are pitfalls too. A depressed stock market may not provide enough opportunities for an arbitrage fund. Besides, it is not necessary that on the day of expiry the price of the stock and its future contract will coincide.

Although arbitrage funds fall in the category of equity funds, the risk associated with equities gets eliminated as the fund manager invests in stocks and their futures simultaneously. Moreover, arbitrage funds score over income funds and traditional options in terms of tax efficiency. Any capital gains arising out of sale of units after one year are taxed at 10%. Short-term capital gains on units sold within one year are taxed at a flat rate of 15%. In comparison, for debt funds, the period for STCG is three years and gains are taxed at one’s applicable tax rate. In addition, the applicable dividend distribution tax (DDT) for arbitrage funds is 10%, as against 25% for income funds.