As tax rules in India evolve, mutual fund companies are launching innovative, tax-efficient products. One such is Income Plus Arbitrage Fund of Funds (FoF), hybrid mutual fund schemes combining debt and arbitrage funds. Sixteen fund houses have introduced these offerings within six months, while more are expected to follow. These funds are gaining popularity because recent tax reforms have made traditional debt funds less appealing.
Income Plus Arbitrage FoFs operate through a fund of funds structure, investing in other funds. These FoFs allocate at least 35 per cent of assets to arbitrage funds and up to 65 per cent to debt-oriented funds. Their appeal lies in the more favourable tax treatment they enjoy under the revised tax rules. Prior to 2023, long-term capital gains (LTCG) on debt funds were taxed with indexation benefits if held for more than three years, reducing the effective tax burden. However, the Finance Act 2023 removed indexation, taxing all debt fund gains at the investor’s income slab, regardless of holding period.
The 2024-25 Budget brought a tax advantage for FoFs with less than 65 per cent in debt and over 35 per cent in non-debt assets. Now, these attract 12.5 per cent tax on LTCG held over two years—without indexation—while short-term gains are taxed as per the individual’s income slab. This makes these FoFs more tax-efficient than pure debt funds, which continue to be taxed at slab rates.
To illustrate, if you were investing ₹1 lakh for two years at 7 per cent annual return results in ₹1,14,490 in both Income Plus Arbitrage FoFs and debt funds, due to tax differences—12.5 per cent for FoFs and 30 per cent for debt funds—tax on FoFs is just ₹1,811 compared to ₹4,347 for debt funds. This gives post-tax returns of ₹1,12,679 in FoFs and ₹1,10,143 in debt funds, favouring FoFs for investors in the 30 per cent tax bracket.
Portfolio composition
Regarding portfolio construction, half of the 16 Income Plus Arbitrage FoFs are new launches; the rest have been repurposed into this structure. All maintain up to 65 per cent in debt and a minimum of 35 per cent in arbitrage-based equity funds. While some fund houses like Axis and Edelweiss follow a multi-manager approach by investing across fund houses, others allocate on in-house schemes.
Debt components are managed dynamically. For example, Edelweiss adjusts duration from 1 to 10 years based on market conditions. Fund houses such as Bandhan, Baroda BNP Paribas, DSP, HDFC and Tata typically hold just two schemes in their portfolio baskets—one for arbitrage and one for debt, often preferring corporate bond funds. Others like Axis, HSBC, ICICI Prudential, Kotak and SBI diversify further, including gilt, long-duration, banking & PSU, and short-duration debt funds. Though portfolio structures differ, fund managers retain flexibility to adjust strategies depending on market scenarios.
Performance
Since these funds are newly launched, the historical performance of the underlying fund categories offers a useful indication of their potential returns.
Over the last seven years, two-year rolling returns show that arbitrage funds delivered an average compounded return of 4.9 per cent. In comparison, medium-term debt funds earned 6.4 per cent, corporate bond funds 6.7 per cent and money market funds 5.7 per cent. A hypothetical portfolio with 35 per cent in arbitrage funds and 65 per cent split equally among these three debt categories, post a 0.10 per cent expense ratio, would give around 5.7 per cent annual pre-tax returns. Investors in the 30 per cent tax bracket would see a post-tax return of approximately 5 per cent from this blended portfolio, outperforming the after-tax returns of medium-term funds (4.5 per cent), corporate bond funds (4.7 per cent) and money market funds (4 per cent). Surcharge and cess have not been factored into this estimate.
Should you invest?
Investors considering these funds should understand several key factors. These FoFs are dynamically managed, and the risk largely depends on the strategies used within underlying debt funds. Fund managers have the discretion to shift allocations, potentially opting for lower-rated credit or longer-duration strategies, increasing risk beyond what conservative investors may tolerate.
Another consideration is cost. These schemes bear dual expenses: one from the underlying funds and another from the FoF itself. Current expense ratios of these FoFs for regular plans range from 0.25 per cent to 0.99 per cent, and for direct plans, from 0.03 per cent to 0.43 per cent. Combined with the expenses of the underlying funds, they can reduce overall returns.
Income Plus Arbitrage FoFs are suited for investors in higher tax brackets—25 per cent or 30 per cent—who have a low-to-moderate risk appetite and investment horizons longer than two years. The tax efficiency offers an appealing alternative to traditional debt funds, particularly in a changing tax landscape. Investors should, however, remain mindful of the associated risks and the role of fund manager discretion in determining returns.
Published on July 5, 2025
