What do we usually do?
Since it is quite convenient, very often the money keeps lying in the Savings A/c itself (also, maybe it is psychologically satisfying to see a big balance in one’s account). But don’t forget - this earns you just 3.5% p.a. interest and that too taxable. Hence, it is not good to keep too much money in the Savings A/c.

The next common thing to do is to make a Fixed Deposit (FD). This may earn you 6-9% interest depending on the tenure. But this too is taxable (if you are in the highest tax bracket, even a 9% FD will fetch you just 6.3% post-tax returns). So, given the fact that there are better alternatives, this too may not be a very intelligent choice. 

What are the Alternatives?
A) Certain debt MFs offer an attractive alternative to Bank FDs. In case you are sure about your investment horizon, you can opt to invest in Fixed Maturity Plans. Else, if you want quick liquidity, liquid plus/floating rate funds could be considered.

FD and Debt MFs give 8% returns. Then if you are in the 30% tax bracket, your post-tax return from Bank FD will be 5.60%. But, if you invest in MFs, you will earn either 7.01% (dividend if period is less than 1 year) or 7.09% (LTCG if period is more than 1 year). 

B)Arbitrage Funds Before we see how arbitrage funds can be useful, let’s first understand the concept of such funds.

Though, arbitrage funds invest in equity and derivatives such as futures & options, they are essentially debt funds. This is because when they invest in equity, they also take an exactly opposite position in futures. The objective is to capitalize on the difference in the prices in the cash market and the futures market (and hence the term arbitrage) rather than making money on equity or derivatives.

For example, say they buy Infosys shares @ Rs.1800/share in cash market on Aug 1. At the same time, they will sell Infosys shares in the futures market, which would be quoting for say about Rs.1815 (the difference in financial parlance is called the ‘cost of carry’).

Let’s say the price of Infosys on the expiry date of the futures contract (last Thursday of the month) is Rs.1900. Thus, the fund will make a profit of Rs.100 in the cash market [Rs.1900 – Rs.1800] and loss of Rs.85 [Rs.1815 – Rs.1900] in the futures market. (On the expiry date the cash and future prices are same). The net gain is Rs.15.

Or suppose the price of Infosys drops to Rs.1700. Thus, the fund will make a loss of Rs.100 in the cash market [Rs.1700 – Rs.1800] and profit of Rs.115 [Rs.1815 – Rs.1700] in the futures market. Again, the net gain is Rs.15

This way, the market movement does not affect them. They earn Rs.15, whatever may be the final price, which in this case works out to about 10% p.a. assured returns (@Rs.15 on Rs.1800 in one month).

in last 6-12 months’ arbitrage funds have given about 9.25% p.a. average returns, while floating rate funds have given around 7.5% returns, liquid plus funds around 7.9% returns and FMPs around 8.5% returns.

 

Now, the key point – for tax purposes arbitrage funds are treated as equity funds. Hence, they enjoy lower tax vis-à-vis debt funds (see table below).

Particulars	Arbitrage Funds	Debt Funds
Dividend Distribution Tax	Nil	14.16%
Long Term Capital Gains Tax	Nil	11.33%
Short Term Capital Gains Tax	11.33%	As per slab
Securities Transaction Tax	0.25%	Nil

 

 

 

Thus they could give even better post-tax returns than debt MFs.

If the period is less than 1 year, both Debt Funds and Arbitrage Funds will give almost the same returns. At 8% pre-tax returns, the post-tax return works out to about 7%. But, if the period were 1 year, then post-tax yield would be 7.09% in debt funds and 7.73% in arbitrage funds.



This means Arbitrage Fund offers the highest return without any risk and it is the best alternative for Fixed Deposits.