Prime Review: Should you invest in Income Plus Arbitrage funds?

If there’s one type of fund that frequently appears in new fund launches and your questions to us, it’s the Income Plus Arbitrage fund. These fund-of-funds promise debt-like returns combined with lower taxation, thanks to the blend of arbitrage funds and debt funds in their portfolios. 

But should you consider them? Let’s investigate.

Taxation – the origin 

Income plus arbitrage funds are classified under the fund-of-funds category. They invest in both debt funds (income) and arbitrage funds. They are expected to give returns comparable to debt funds and qualify for long term taxation of 12.5% as per current tax rules.

It is the tax changes in debt funds that gave birth to this new debt-plus-arbitrage category. Let’s trace this history.

The tax change: Up until 2023, short-term capital gains from debt funds were taxed at your slab rate, and long-term capital gains enjoyed favourable taxation: 20% with indexation benefits. A holding period of 3 years was used to determine if gains were short-term or long-term. This made them very tax-efficient compared to fixed deposits and a great debt investment vehicle.

However, this favourable treatment ended in 2023. From April 1, 2023, all capital gains from debt mutual funds regardless of holding period are taxed at the investor’s slab rate. This removed the distinction between short- and long-term gains and abolished the benefit of cost indexation. (Note: this tax rule applies for fresh investments in debt funds made after April 1, 2023)

In FY-24, tax rules changed again, especially with regard to fund-of-funds. As you may know, a fund-of-fund invests in different funds. From FY24, the tax treatment of FoFs depends on the underlying asset allocation. FoFs that invest at least 65% in debt (either directly or via debt mutual funds) continue to get classified under debt taxation. FoFs with less than 65% allocation to both debt and equity now have the following taxation: 

• Long-term capital gains (after 2 years) taxed at 12.5% without indexation
  
• Short-term gains are taxed at the investor’s slab rate.

The impact: With the 2023 tax rule, debt funds suddenly went from a great tax-efficient option into a tax-heavy option. This shift sent investors seeking favourable tax treatment to arbitrage funds. Arbitrage funds offer debt-like (comparable volatility) behaviour and return, since their entire equity exposure is hedged through derivatives, but are taxed as equity. 

However, arbitrage fund returns are typically similar to liquid funds (and sometimes lower) and are lower than other debt funds as well. For higher returns, one would then have to turn to equity savings funds, which hedge a good part (but not all) of their equity portfolio. Equity savings funds offer equity taxation, higher returns than debt, and lower volatility than other hybrid funds. But they are not in the same risk category as debt funds, owing to their unhedged equity and, during periods of steep market correction, cannot be expected to always outperform debt funds.

This opened up an opportunity for AMCs to blend arbitrage and debt in the structure of a fund-of-fund. And so by late 2024, AMCs began launching income plus arbitrage fund-of-funds (also called debt plus arbitrage FoFs). These funds invest:

• Less than 65% in debt mutual funds from any category – corporate bond, short duration, gilt, banking & PSU etc
• At least 35% in arbitrage funds.

The tax advantage: Income plus arbitrage FoFs claim the following benefits:

• Lower volatility: Since these funds avoid unhedged equity exposure, they are expected to be far less volatile than equity savings funds. 
• Higher returns: Having up to 65% in debt improves return potential over pure arbitrage funds. 
• Crucially, they qualify for favourable long-term taxation of 12.5% after 2 years

How these funds are constructed

Although the concept of these funds are new, some may appear to have a long track record. That’s because several AMCs have repurposed existing FoFs by modifying their fundamental attributes to create income plus arbitrage funds. Any history we have for these funds is relevant only from the point of the change in mandate.

So far, the funds launched follow an actively managed strategy. They invest slightly more than 35% in arbitrage funds to ensure that the debt allocation remains below 65%, preserving tax efficiency.

On the debt side, most funds currently invest in corporate bond funds and banking & PSU debt funds, with some exposure to other debt fund categories. This allocation may well change over time based on the fund manager’s view of which debt categories are expected to perform better. At this point, corporate bond funds offer a good mix of higher-interest accrual and some capital appreciation as yields dip.

As of April 2025, the average portfolio of income plus arbitrage funds is structured as follows:

Of course, there are differences between funds. While the income plus arbitrage FoFs from Bandhan, HDFC, and ICICI Pru invest almost all of their debt allocation in corporate bond funds, DSP Income Plus Arbitrage FoF invests the majority of its debt portion in banking & PSU debt funds. Others, such as those from Axis, Aditya Birla Sun Life, and HSBC maintain a more diversified allocation across multiple debt categories.

What returns can you expect?

Let’s begin with what NOT to consider: the past performance of income plus arbitrage funds that you see currently. As mentioned above, all existing funds with long track records have undergone a change in fundamental attributes, making their past performance data irrelevant.

Below is a list of current Debt Plus Arbitrage funds, along with their former names and the month they transitioned to the new structure:

As you can see, we have less than a few months’ data to assess any performance. Therefore, DO NOT go by the 1/3/5 year returns or any other returns you see for these funds. 

Step 1: Estimating average debt returns

It is important to understand how these funds can potentially deliver. This is because shifting out of debt and into these FoFs needs to be return-accretive, on a post tax basis. Since we can’t rely on historical performance, we have used the income-plus-arbitrage portfolio structure and historical returns of debt funds to arrive at an estimate of how these funds perform against pure debt funds.

Then, to analyze the usefulness of income plus arbitrage funds in a portfolio, we considered two scenarios: 

• One, for those with a short-term investment horizon looking for a low-volatile fund that offers better returns and favourable tax. For this, we took 2-year returns (since 2 year holding is required for the favourable tax rate of 12.5%).
• Two, for those who are looking for a tax-efficient route to debt funds in their long-term portfolios. For this, we took 3-year returns.

We took the rolling returns for the above timeframes from 2018 to date for major debt categories and arbitrage funds (i.e., the period since the 2017 recategorization so debt category returns are more relevant). The table below shows the average of these rolling returns. 

Step 2: Estimating potential income plus arbitrage FoF returns

As a Fund of Funds, these schemes carry their own expense ratio. Based on April 2025 portfolios, most of these funds charge very low fees—all but one have an expense ratio of 0.1% or lower. To assess the potential performance of income plus arbitrage funds against pure debt funds, we assumed the following allocation: 

• 16% each to four debt categories – banking & PSU, corporate bond, gilt, short duration
• 36% to arbitrage funds
• and a 0.1% FoF expense ratio

Based on this, the estimated pre-tax returns of income plus arbitrage FoFs work out to:

• Rolling 2-year return: 6.47% 
• Rolling 3-year return: 6.06% 

If you compare these returns against the debt fund average above, you will see that they deliver below any debt category in both 2 year and 3 year periods. This is not too surprising, as a third of the FoF portfolio is locked in low-returning arbitrage. 

The real advantage of these funds lies in their post-tax returns. The tables below show how they look across tax slabs for the same portfolio structure. We have highlighted the debt category that is most recommended and suitable for the 2 & 3 year holding periods for your easier comparison.

Observations

The returns above suggest that income plus arbitrage funds can generate better post tax returns for those in the tax brackets of 25% and 30% in the short and long term. For those in lower tax brackets, pure debt funds work better on a post-tax basis. 

However, before you ditch debt for these FoFs, we recommend the income plus arbitrage FoFs for only those in the 25%-30% tax bracket who have a time horizon of 2-3 years only. For those in the 25% tax bracket, note that the post-tax return differential is unlikely to be very significant.

The 2-year period offers some extent of certainty in tax rates and more predictability in the debt strategy of the funds. The return differential in the 2-year period between short duration funds and income plus arbitrage funds is also quite significant for those in the 30% tax bracket. The rolling return analysis also indicates that income plus arbitrage funds would beat short duration funds (post tax) all the time.

The reasons behind us not recommending income plus arbitrage funds for the long term – especially given the extreme newness of the category – are as follows:

Unclear long-term advantage: The advantage income plus arbitrage offers is not very clear in long-term periods. Longer-term debt fund categories deliver much higher returns than income plus arbitrage, which puts a bigger dent in the tax advantage. A closer look at return distribution shows that there are times when pure gilt funds do better than income plus arbitrage funds, even on a post tax basis. 

If we take the average 5 year rolling return over the past 8-year period, gilt and corporate bond fund returns are much higher than the 3 year returns. This means that the likelihood of these debt funds beating income plus arbitrage is even higher.

Even if you consider a scenario where you will need to redeem debt funds as part of rebalancing your long term portfolio, it is not a given that income plus arbitrage will be an advantage. Imagine these funds giving a pre tax return of 6.06% and a corporate bond fund giving 6.66% (as per 3 year rolling return analysis we saw earlier). 

Now let’s say you redeem about a third of debt assets as part of rebalancing after 5 years and the current tax rates apply. Post tax, you will still have a higher value remaining in the debt fund than in the income plus arbitrage fund. The illustration below shows how this works out for Rs.100 invested:

Essentially, it entirely boils down to the returns of each fund – and this is where the next uncertainty with income plus arbitrage crops up.

Risks from FoF composition: The risk in income plus arbitrage comes from the underlying debt strategy. The composition of debt will be at the discretion of the fund manager. 

For example, if we were to change the income plus arbitrage composition in our example above, to say, comprising only short duration and banking & PSU funds, the 3-year post-tax return differential reduces by about 7 basis points over corporate bond or gilt funds. If we were to change the FoF composition to only corporate bond and short duration, the differential reduces only marginally. 

Therefore, the FoF’s composition plays a big role in its returns – and you have no control over where the fund invests. Any ill-timed call on interest rate movements or type of debt fund chosen could negatively impact returns. The FoFs offer less transparency in portfolio positioning, making it difficult to predict its risks.

Another risk is the performance of the underlying funds the fund-of-fund invests in. Poor performance of the debt fund the FoF invests in can remove any tax advantage, especially given that the post-tax return differential is not very significant.

These factors make it important for the fund to prove its ability to make the category and fund calls right before considering those for long-term investments. At this time, there is just no information to make a judgement.

This apart, any potential increase in expense ratio is also a risk that may tilt the equation, especially already we see the advantage of post tax returns, even for those in the 30% slab is in the range of 0.4% to 0.5% only.

No predictability over tax rates: Future post tax returns could change materially over the long term due to change in taxation or change in one’s personal financial situation. For example, one may see a slight advantage now based on 12.5% taxation on the income plus arbitrage fund and 30% on the debt fund. But if the last few years is anything to go by, it is that taxation is always liable to change. 

So if the 12.5% rate were to change to 15%, it can throw off any calculation. Or if at the time of redemption, you wind up in a lower tax bracket, the estimated advantage may vanish. Or if the tax slabs change (as it did in the Budget 2025, making incomes of Rs 12 lakh and below tax-free), any calculation you do today will be irrelevant.

Conclusion

To summarize, our preliminary analysis suggests that income plus arbitrage FoFs may deliver higher post-tax returns than debt funds for investors in the 25% and 30% tax slab who wish to invest for a 2-3 year period and avoid equity market volatility. While equity savings funds have the potential to generate higher returns than debt plus arbitrage funds, they carry equity market risk and are not debt fund substitutes. 

At this point, there is just not enough information to estimate how good this new category will turn out to be over the long term. Going by historical debt fund returns, the income plus arbitrage FoFs are not an out-and-out winner for us to make an unequivocal recommendation. 

There is always strong demand for tax-saving products, and AMCs do their best to meet that need. While there’s no harm in considering tax efficiency once you’ve shortlisted suitable options, tax-saving should not be the primary objective when selecting an investment.