Arbitrage Mutual Funds

An Arbitrage Mutual Fund is a type of hybrid mutual fund category that aims to generate returns from the price disparities of the same asset in different market segments, mainly the cash and futures markets. As per SEBI’s categorisation circular, arbitrage funds shall have to allocate a minimum of 65% in equity and equity-related instruments. The debt portion can be invested only in government securities with a maturity of less than one year and in repo transactions involving government bonds.

• Equity-oriented: These funds invest a minimum of 65% in equity and equity-related instruments. 
• Open-ended: These funds are usually open-ended, investors have the flexibility to buy or redeem units whenever they want.
• Lower risk profile than pure equity funds: Due to their hedged nature, arbitrage funds generally carry lower risk compared to pure equity-oriented funds.

• The fund manager looks for opportunities where the same security is available at different prices in the cash and futures markets.
  
• The fund buys stock in the cash market. At the same time, the fund sells the futures contract of the same stock for similar expiry.
  
• If the futures price is higher than the cash price, the difference is known as the gross spread.
  
• As the futures contract nears its expiry date, the prices in the cash and futures markets usually converge.
• Arbitrage mutual funds generate returns by capitalizing on the price difference between the cash market, where securities are traded immediately, and the futures market, where trading occurs for a future date. 
• In futures market buyers and sellers enter into a binding agreement at a predetermined price to purchase or sell the underlying asset at a specified future date. 
• When the trade is settled, the fund earns the difference between the buying and selling prices. 

Let’s understand this further with an example. Suppose the shares of ABC Company are trading at: 

1. Per share price at cash market: Rs 1,000
2. Per share price at futures market: Rs 1,030

An arbitrage fund manager identifies this price difference and buys the shares of ABC Company in the cash market and sells in the futures market. So the price difference = Rs 1,000 − Rs 1,030 = Rs. 30 per share. This is how they take advantage of price differentials in different markets to come up with a scenario to earn profit. The difference secured upfront represents the potential return, after accounting for expenses.

You can invest in an arbitrage fund using Paisabazaar. Below is the step-by-step process to do this: 

• Step 1: Open the Paisabazaar app and click on the “Mutual Fund” icon.
• Step 2: Choose a fund that matches your financial goals and risk preferences.
• Step 3: Then choose your investment method - Lump sum or SIP investment.
• Step 4: Enter the investment amount and complete your KYC verification to start investing.

Since these funds invest 65% or more in equity funds, they are taxed as per the rules on equity funds:

• Short-Term Capital Gains (STCG): If you redeem your investment within 12 months, the gains are taxed at 20%.
  

• Long-Tl Gains (LTCG): If you redeem your investment after 12 months, the capital gain will be classified as a long-term capital gain and taxed at 12.5%. However, gains up to ₹1.25 lakh are tax-exempt.