Investors seeking safe yet rewarding investment avenues often weigh options like Fixed Deposits (FDs) and Equity Arbitrage Funds. However with the changes introduced in the last Union Budget, one should now also evaluate a new category of investments called Income Arbitrage Funds. Each of these investment options comes with its own set of advantages, risks, and tax implications. To help you make an informed choice, here’s a comprehensive comparison of these three investment categories.
Fixed Deposits (FDs)
Overview:
Traditional savings instruments offered by banks and financial institutions, FDs are favoured for capital safety and assured returns.
Pros:
– Capital preservation with guaranteed interest.
– Easy to understand and invest.
– Flexible tenure options.
Cons:
– Low returns relative to inflation, typically around 5-7%.
– Penalties for early withdrawal (may vary by financial institution)
– Fully taxable interest, reducing net post-tax returns.
Outlook:
With current bank FD interest rates around 5-7%, FDs are steady but generally a poor investment tool with low post-tax returns. Future returns are expected to stay within this range or may even drop in line with falling interest rates (as India heads towards becoming a developed economy, interest rates are expected to trend lower in the long term).
Equity Arbitrage Funds
Overview:
These are mutual fund schemes that invest in a combination of low risk debt securities (<35% of portfolio) and equity arbitrage opportunities. The equity arbitrage opportunities focus solely on exploiting price differences between the cash and equity derivative prices, and are completely hedged resulting in low volatility and steady returns.
Pros:
– Low volatility
– Less market-dependent compared to pure equity investing.
– Tax benefits: Gains taxed at 12.5% for holdings beyond 1 year.
– Low risk relative to direct equity investments.
– Such funds are the only low-risk investment that thrive in volatile markets.
Cons:
– Low returns of 6-7%
– Can be affected by market stability; returns can fall if equity markets are stable
– Slightly higher expense ratios compared with liquid funds
Outlook:
Historically, Equity Arbitrage Funds have provided annual returns of around 5-8%. Expectations remain similar if market volatility persists, though returns may fluctuate based on arbitrage opportunities.
Income Plus Arbitrage Funds
Overview:
Income plus arbitrage funds are a type of hybrid mutual fund that invests in both debt instruments for stable returns and equity arbitrage opportunities in the stock and futures markets for potentially higher, tax-efficient returns. The aim is to offer stability of debt with the tax efficiency of equity making this an interesting innovation introduced in the last year or so. These funds will hold less than 65% in debt (but near it) and over 35% in arbitrage, thereby allowing it to take advantage of the recent Budget changes which provide for capital gains tax at 12.5% if the investment is held for at least 2 years.
Pros:
– Higher returns (~7-8.5% annualized).
– Since significant part of the portfolio is in debt, any reduction in interest rates could result in additional gains
– Tax advantages: Long-term gains taxed at 12.5%
Cons:
– Returns may drop if interest rates rise.
– Most of these funds operate as Fund of Funds and therefore have slightly higher expense ratios compared to liquid funds
– Tax advantage only if held for more than 2 years
Outlook:
This is a new innovation that is likely to provide slightly higher returns when compared to equity arbitrage funds or FDs. They provide best of both worlds with stability and tax efficiency. Expect pre-tax returns of ~8% with returns likely to go up if RBI cuts interest rates.
These funds are gaining popularity for their combination of safety, predictability, and tax-smart features, making them suitable for conservative investors or those seeking tax benefits for long-term goals.
Comparison of FDs vs Equity Arbitrage Funds vs Income Plus Arbitrage Funds
| Investment Option | Approx. Pre-Tax Return (%)* | Tax Rate | Approx. Post-Tax Return (%)* | Remarks |
| Fixed Deposits | 5-7% | Fully taxable at investor’s slab rate (30% if in highest slab) | 3.5-5.6% | Post tax returns do not beat inflation. Consider only for short term needs. |
| Equity Arbitrage Funds | 5-8% | 12.5% capital gains tax if held for more than 1 year | 4.56-7.30% | Suitable for conservative investors with holding period of 1 to 2 years |
| Income Plus Arbitrage Fund of Funds | 7-8% | 12.5% capital gains tax if held for more than 2 years | 6.39-7.3% | Smart option if you can hold for 2 years or more |
*(Note: Actual net returns depend on individual tax slabs, holding periods, and market conditions)*
Conclusion:
Choose FDs if capital safety and predictability are your priorities and you are content with lower returns. These are more suitable for shorter periods.
Invest in Equity Arbitrage Funds if your goal is higher post-tax returns with slightly more risk than FDs.
Opt for Income Plus Arbitrage Funds if you seek a balance of moderate risk with higher post-tax returns, and you can remain invested for 2 years or more.