Can I invest my Emergency Fund in arbitrage?

By Mohasin Athanikar |  12-08-20 | 
 
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About the Author
Mohasin Athanikar is an Investment Analyst for Morningstar Investment Adviser India.

My Emergency Fund is Rs 8 lakh and is in a bank fixed deposit. I am in the 30% tax bracket. So to save tax, should I move that money into an arbitrage fund? What sort of fund would you suggest to earn a minimum average return of 7-8%? Also, suggest debt funds as I would like different amounts in different tenures.

This is broadly what I want, but I am open to modifying it since I have no immediate requirement.

  • Rs 1 lakh (1-3 months)
  • Rs 2 lakh (3-6 months)
  • Rs 2 lakh (12 months)
  • Rs 3 lakh (12-36 months)

Before I answer your query, let me explain a few basics.

3 things to note about an emergency fund.

Everyone must have it. It is a very smart financial move. Where the variability sets in is in the actual amount. Broadly, six months of expenses are set aside. However, this is not written in stone. It will depend on your individual situation and the number of dependents you have. We have written about it in The need for an emergency fund.

It is only for emergencies. The emergency fund is only to be drawn upon in an event of dire need. Typically, events such a medical emergency, job loss, unexpected business expenses, etc. warrant the use of such a corpus.

Liquidity is of importance. Given the purpose of investment, the corpus should be readily accessible on demand. Hence, the money should be invested into very high credit quality (safer) and liquid instruments, as safety and liquidity are the prime concern here, while returns take a back seat.

4 things to note about an arbitrage fund.

Where they invest. These are hybrid funds that take arbitrage positions in equity and related instruments for at least 65% of the portfolio. The remaining corpus is mostly in high-quality fixed-income instruments and cash.

How they make money. These funds buy securities in the spot market and simultaneously sell them in the futures market. They buy the stock in the lower-priced spot market and sell it in the higher-priced futures market. These funds aim to capture the price differential between spot and futures markets, which is largely aligned with money market rates. Hence, the returns for these funds are close to that of liquid funds.

Tax. From a post-tax perspective, arbitrage funds are favorable since gains for holding periods less than 1 year are taxed at 15% (30% for debt funds); while in case of holding periods of more than 1 year, only gains in excess of Rs 1 lakh per annum, are taxed at 10% (30% for debt funds). These funds typically have an exit load of up to one month.

Risk. One should be mindful of the risks in these funds. The spot and futures positions are marked-to-market on a daily basis, and hence there may be periods when these funds experience a drop in their NAV. Also, the debt portion too may see a drop in valuation assuming issuer downgrades or a rise in interest rates.

So where must you invest your money?

Since 2019, the Reserve Bank of India, or RBI, has cut the policy rate sharply and announced a slew of measures to support the slowdown in the economy, which has recently got further aggravated due to the COVID-19 pandemic. The measures announced along with abundant liquidity in the banking system have resulted in yields falling substantially, particularly at the shorter end of the yield curve. This is also reflected in the yield to maturity of shorter duration funds. Banks too have cut down on deposit rates.

Given the liquidity needs, liquid and ultra-short duration funds may be considered as an alternative to bank fixed deposits, or FDs. Funds belonging to these categories are not subject to any exit loads on withdrawal, as compared to penalties charged in case of premature withdrawals in FDs. Also, assuming that the emergency corpus in held for more than 3-years, the interest received in FDs would be charged as per your income tax bracket and taxed each year, while the capital gain in case of investments made in the growth plan of debt funds would only be charged on redemption, and taxed at a lower rate of 20% post indexation.

Given the favorable taxation of arbitrage funds relative to liquid funds and fixed-deposits, you can look to invest about 70% of the required emergency corpus into arbitrage funds and rest (30%) into liquid funds for access to immediate liquidity. Liquid and ultra-short term funds have a high credit quality portfolio (low credit risk), with minimal interest rate risk.

For amounts in excess of the required emergency corpus, you can consider low duration, Banking & PSU debt funds, and corporate bond funds with an investment horizon of up to 3 years. Look for portfolios which invest in high credit quality instruments. However, these funds do carry some interest rate risk.

We suggest that you consult your financial adviser before making any investment decisions.

You can look at fund performance here. The views of our analysts on select funds can be accessed here.

Registered readers can post their queries by accessing the Ask Morningstar tab. Our team will answer SELECT queries ONLY relating to mutual funds and portfolio planning.

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ninan joseph
Aug 12 2020 07:59 PM
 Sir, By the very definition of Emergency fund, this should be placed at the most liquid and accessible investment asset and according to me it should be Bank FD. Every tax payer gets the first 250,000 as no tax. Consider this amount coming under that or you give 15G for this deposits so that TDS is not calculated. Emergency funds cannot be kept in any fund whatsoever except bank deposit. The intention is safety of the deposit and not returns. You could also consider RBI savings bonds or bharath bond or Gilt funds. This is the second option in case you are really worried about tax. These are my personal opinion only.
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