What are Arbitrage Funds – Definition, Advantages, Taxation

Arbitrage Funds are a type of mutual funds that profit from the price differential of the equities in the cash market and derivatives to generate returns. It leverages from volatile markets.

What are Arbitrage Funds?

The very term ‘arbitrage’ means simultaneous buying and selling of securities and others like commodities, currencies in different markets to take advantage of the differing prices of the same assets in different markets. Arbitrage Funds are essentially equity funds as these funds invest majorly in buying equities and generating returns by exploiting the price differences of shares in different markets. These capitalize on market inefficiencies and profits depend on volatility of the assets. Arbitrage Funds are usually bought in the cash market and sold to futures markets to earn maximum returns from price differences of current and future securities.

Typically, a fund purchases stocks with a view to sell it when the stock prices go up in a bullish market. The current price at which a share is bought in the cash market (in which stock trading occurs) is the spot price. In futures, the stocks are not valued at the spot price or current price in the market but an anticipated price of the future. Futures market is a derivative market (a financial security dependent on underlying assets and derives its price from fluctuations in assets). For example, if an stock of a XYZ company is trading at ₹50 and it is anticipated that it will rise up to ₹70 in a bull market, then arbitrage funds buy stock from the market and sell a contract in the futures market. Vice-versa, arbitrage funds buy lower priced contracts from futures and sell in the cash market at higher price if the market is bearish.

Who should Invest

• Investors with a low risk profile can go for Arbitrage Funds as when markets are stable then not much price differentiation occurs and hence not much of benefit or a loss is possible. But when markets are volatile, arbitrage funds benefit from fluctuations
• Although there are other low risk investment options available but if investors want to have high gains from a high volatile market but also want to take calculated risks, then this fund is for them
• If an investor is looking to invest for short to medium duration then an investor may go for this fund

Benefits of Investing in Arbitrage Funds

• Low Risk

Arbitrage Funds are low risk buy and sell opportunities in cash and future markets. Their low risk is often compared to that of a Debt Fund. Thereby, an investor looking for gains from an equity fund and wanting low risks as that of a debt fund has an advantage through investment in arbitrage funds

• Suitable for Unstable Markets

It is an added advantage that most of the funds may give negative returns or get unpredictable in a highly unstable market, whereas this mutual fund is the only low risk security that flourishes in a volatile market. Here, gains and volatility go together. One the other hand, it is also the drawback of this fund that it under performs in a stable market

• Taxed as Equity Funds

These funds are basically hybrid funds but they are taxed as equity funds as equities represent an average of 65% in this fund. If you hold the funds for more than a year, then it will be taxed as long term capital gains

Things to be considered before investing

Every investment requires a sufficient amount of research and valuation of factors such as risks involved, history of returns accrued, business proficiency of the holdings etc. Here are some of the things which must be considered by an investor before investing into the Mutual Funds:

1. Financial Goal– Before making any investment decisions, it is very important to evaluate that the fund objective is aligned to your financial goals. If you want to park your money for a short period and to have an edge over Debt Funds, for higher gains, taxation benefits and low risk then you may try investing in this fund
2. Fund Performance– Measuring the performance of the fund in both bullish and bearish market situations is a necessity as it helps the investors in selecting a reliable fund. Arbitrage Funds are not supposed to perform in a consistent market and are known for their mediocre reliability. These funds behave more as bond funds in stable market and then actively managed equity funds outperform
3. Fund House & Management– There are numerous Mutual Funds regulated by different AMCs (Asset Management Companies). Fund houses & Fund Managers play a very decisive role in the allocation of assets and selection of stocks. If the management has enough experience and expertise, the fund will easily sail through promising market conditions and deliver good returns
4. Costs Involved– There are different costs involved in Mutual Fund investments such as Expense Ratio, Entry Load and Exit Load. Investors must review these costs before heading up for investments. Arbitrage Funds generally have higher Expense Ratio because of higher number of trades required for purchase and sale of stock and contracts in various markets
5. Other Basics from the Portfolio: There are other different factors such as the fund NAV (Net Asset Value), AUM (Assets under Management) etc. which are to be viewed to make sure of the reliability and investor engagement in the fund

Top 10 Arbitrage Funds to invest in 2020

(Source: Value Research, as on February 6, 2020)

Taxation

These funds are taxed as Equity Funds. If an investor has made a capital gain of ₹50,000 on investment in an equity fund, Short Term Capital Gains Tax of 15% would be levied if s/he withdraws the amount within one year of investment. The payable tax would be ₹7,500.

Also, if an investor has made a capital gain of ₹1.5 lakh on investment in an equity fund, and withdraws the amount after 1 year of investment, Long Term Capital Gains Tax of 10% would be levied on ₹50,000. ₹1Lakh is exempted from taxation. The payable tax would be ₹5000.

How to Invest in Arbitrage Funds

• Offline mode of investing– If you are not confident of your knowledge, you may choose to invest through a broker. However, investing in a fund through a broker will make you eligible for investments through regular plans that offer different returns and varied expenses in investment. If you wish to invest in the fund independently, you must visit the nearest branch of the AMC of your fund. Don’t forget to carry the following documents-
  • Identity Proof (Aadhar Card)
  • Cancelled cheque
  • Passport size photos (around 4-5)
  • PAN Card
  • KYC documents (for KYC verification)
• Online mode of investing– If you do not wish to add on to your expense of commissions or brokerage, you may visit online investment platforms such as Paisabazaar.com wherein you can choose from and compare more than 1,700 funds- all in one place, instead of following the long procedure of visiting the website of each AMC and then choosing from them. Here, you can select the fund in which you want to invest, look at the details and compare similar schemes as well as use SIP Calculator or Lumpsum Calculator to estimate the future value of your investment

For detailed information on how to invest in mutual funds, click here