Will They Unwind?

Mutual Funds have been by far the biggest buyers in Indian equity markets for last two years now. With total assets under management at  Inr 21.37 trillion of which equity assets at Inr 8.43 trillion and Inr 1.67 trillion in balanced funds (part of which is equity), they have been leading the upmove for a while now. Since the start of this financial year they have been net buyers of ~Inr 1,00,000 crores, while FII inflows have been flattish during this time. Net- net they lead the upmove in Indian equity markets.

This strength comes largely from saving of individual investors and corporate. Post demonetization and reduction in interest rates of fixed deposits, lot of money has been finding its way into equities. This is largely done via SIPs. In addition, in a Nifty was up by ~33% since April 2016, the rewards for investors have been quite handsome.

One interesting product, which has been seeing good inflows are arbitrage funds. The arbitrage funds in India currently have an AUM of nearly 70,000 crores. The trick out here was the tax arbitrage. Any equity investment above 1 year would not attract any tax. In order to be defined as an equity fund, 65% of the investments should be in equity instruments.

Thus, if these fund invest in equity arbitrage atleast 65% of the corpus and remaining goes in debt market related instruments. With this one would get near debt market returns at very low risk and the money would be tax-free after 1 year, as compared to debt market where this rule is 3 years. This made it a clear case of tax arbitrage.

However, this year’s budget speech, has taken away this particular benefit. The Mutual fund dividends or benefit from any equity related instrument will be taxed at 10%. This will lead to decent diminishing in the returns earned by these funds. More importantly it takes away a critical reason/ benefit of investing into these funds.

Arbitrage funds have given ~6.3% returns for last 1 year. The number of last 3 years and 5 years is 6.7% and 7.5%. Clearly the returns have been gradually reducing. Also, the average number is due to the higher returns generated by few funds with low AUMs. The funds with decent size are near 6% in terms of 1 year returns.

On top of that, there is an additional tax liability of 10%, this shall push returns below 5.5%. Now the returns are close to FD/Money market returns with more certainty of returns. In addition, arbitrage is a bull market product. Spreads tend to improve during bull markets. With markets in a weak situation, there are little chances of the spreads to improve in the near future. This creates a very strong case where there can be decent redemptions.

If we assume, average equity holding of ~70% in equity by these funds, that translates to total equity exposure of nearly 50,000 crores. Assuming that there is a 30% redemption that would be mean selling of nearly 15,000 crores. With March being the last month before the implementation of LTCG, there is a bright chance that the redemption can be triggered this month.

Large part of the redemption would happen during the expiry week. Markets are not poised to absorb such a loss and can be hurt. The happening off this event would depend whether the holders of Arbitrage funds do or do not unwind.

Happy Trading

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