What is an arbitrage fund? Key features and taxation

Investors are always in search of investment avenues that offer favourable risk-reward ratios. Those who wish to take a relatively lower risk but get reasonable returns can opt for arbitrage mutual funds. Arbitrage funds invest at least 65% of their assets in equity and equity-related instruments but are relatively low-risk and may generate potentially better returns than debt funds.

Let’s look at what arbitrage funds are and how they work.

Table of contents

What are arbitrage funds in India?
How do arbitrage mutual funds work?
Features of arbitrage funds
Taxability of arbitrage funds
Factors to consider before investing in arbitrage mutual funds in India
Who should invest in arbitrage funds?
How to invest in arbitrage funds?

What are arbitrage funds in India?

Arbitrage Funds fall under the hybrid mutual fund category. These funds are distinct in their investment approach and aim to generate returns from the price disparities of the same asset in different markets, mainly the cash and futures markets.

The term "arbitrage" refers to the process of buying an asset in one market while simultaneously selling it in another, exploiting the price difference to yield a profit. In the context of arbitrage funds, this involves taking advantage of price discrepancies between the cash and futures markets of stocks or other eligible securities.

How do arbitrage mutual funds work?

Arbitrage funds exploit the pricing disparity of securities across markets. These price differences can occur due to various factors such as supply-demand imbalances, market inefficiencies, or differences in trading volumes.

Cash market

In the cash market, arbitrage funds buy stocks or securities at the prevailing market prices. These assets are typically selected based on their liquidity and the arbitrage opportunities they offer.

Futures market

Simultaneously, arbitrage funds sell equivalent positions in the futures market. Futures contracts are essentially agreements to buy or sell an asset at a predetermined future date and price. By selling futures contracts, the fund locks in a future selling price for the assets they hold in the cash market.

Features of arbitrage funds

Potentially stable returns

The ability to generate potential returns, regardless of the market's overall movement, appeals to many investors seeking stability and security.

Relatively stable

Their relatively low-risk nature provides a certain level of comfort during periods of heightened market volatility.

Hedged positions

Unlike other investment options that can be adversely affected by sharp market downturns, arbitrage funds tend to maintain their value due to their hedged positions.

How are arbitrage funds taxed?

Arbitrage funds are typically taxed as equity-oriented funds as they invest predominantly in equity and equity-related instruments. The tax rates are as follows:

Short-term capital gains (STCG) tax: Gains from units sold within 12 months are considered short-term. STCG is taxed at 20%.

Long-term capital gains (LTCG) tax: Gains from units sold after 12 months are considered long-term. LTCG is taxed at 12.5% after a Rs 1.25 lakh exemption per financial year.

This is one of the benefits of arbitrage funds, as they are relatively stable like debt funds, but benefit from equity taxation, which is more favourable than the tax norms for debt mututual funds.

Factors to consider before investing in arbitrage mutual funds in India

Investment objective: Clarify your investment objectives, whether they are capital preservation, moderate growth, or tax efficiency.

Risk tolerance: While arbitrage funds are generally considered low risk, they are not entirely risk-free. Understand your risk tolerance and ensure it matches the fund's risk profile.

Tax implications: Be aware of the tax implications associated with these funds, especially the tax treatment of gains if held for a certain duration. Consult with a tax advisor if needed.

Fund selection: Choose a fund with a consistent track record, expert fund managers, and a low expense ratio. Research various funds to find the one that aligns with your objectives.

Who should invest in arbitrage funds?

You should consider investing in arbitrage mutual funds if:

You have a low-risk appetite.
You have an investment horizon of at least 6 to 12 months.
You want to tap into the investment opportunity in volatile market conditions.
You want to build a contingency fund.

How to invest in arbitrage funds?

Follow these steps to invest in arbitrage funds:

Choose a fund: Compare funds from different Asset Management Companies. Check the fund’s investment approach and fund manager’s experience. Look at historical returns data, if available, but remember that past performance may or may not be sustained in the future.
Select an investment platform: You can invest directly through the asset management company (online or offline) or through a registered mutual fund distributor. You can also invest through third-party aggregator platforms.
Invest in the fund: Complete the KYC process if you are not KYC validated. Submit necessary information and choose between lumpsum or Systematic Investment Plan (SIP). Choose a suitable payment method and initiate the transaction.

In conclusion, arbitrage funds are suitable for conservative investors who have an investment horizon of at least 6 to 12 months. They carry a lower level of risk as compared to equity funds and usually offer relatively reasonable returns than debt funds like liquid funds. If you want to tap into the investment opportunities arising during volatile market conditions, then arbitrage mutual funds can be a suitable investment option for you.

FAQs:

What is an arbitrage mutual fund ?

An arbitrage fund aims to profit from price differentials in securities between the cash and derivative markets.

What makes arbitrage funds a preferred option?

They offer relatively stable returns with lower volatility compared to equity funds, making them a suitable option during uncertain market conditions.

What should investors consider before investing in arbitrage funds?

Liquidity, tax efficiency, and the fund's track record are crucial factors to evaluate when considering arbitrage funds for your portfolio.

Are arbitrage funds high-risk?

Arbitrage funds are generally considered to be relatively lower risk as they capitalise on temporary price differences in the market, without being reliant on long-term trends or speculations. However, they are not risk-free. Market fluctuations can still impact returns, and there’s no guarantee of returns.

Should I invest in arbitrage mutual funds?

The decision to invest in arbitrage funds depends on your risk tolerance and financial goals. They may be suitable for investors seeking relatively stable returns in the short term, but may not be suitable for long-term growth potential. So, investors with a higher risk tolerance and a long investment horizon may find regular equity-oriented funds more suitable.

What are the expected returns of arbitrage funds?

Arbitrage funds have the potential to deliver reasonable returns that may be better than those offered by savings accounts and comparable to those offered by debt funds with short maturity profiles. However, actual returns depend on market conditions and the fund manager's strategy. Moreover, past performance is not an indicator of future results.

What are the risks involved in investing in arbitrage funds?

Market fluctuations can impact arbitrage activities. In some conditions, there may not be enough of a price difference between two markets. Moreover, a delay in identifying opportunities and executing trades can reduce profits, since arbitrage opportunities are usually brief. Liquidity issues, rising interest rates and regulatory changes can also impact arbitrage trading.

Are arbitrage funds taxable?

Yes, arbitrage funds are taxed as equity funds. Gains from units held for over 1 year are taxed as LTCG at 12.5% (on gains exceeding Rs 1.25 lakh). If held for less than 1 year, gains are taxed at 20%.

How much money should I invest in arbitrage funds?

The investment amount depends on your financial goals, risk tolerance, and asset allocation strategy. Consider diversifying your portfolio across different asset classes. Consult a financial advisor to determine a suitable allocation to arbitrage funds within your overall investment plan.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully. This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.