Investing in Arbitrage Funds? Know the Benefits and Drawbacks

Arbitrage funds work by exploiting the price imbalance between the cash (stock) and derivative markets. When the market reflects a bullish sentiment, these funds purchase stocks at a low price from the cash market and sell them at a higher price in the futures market.Conversely, when the prices are anticipated to drop in a bearish market, these funds buy futures contracts at relatively low prices and sell equivalent shares in the stock market at the spot price (current market price at which securities are bought and sold).They also capitalize on arbitrage opportunities in the exchange market, by taking advantage of the fluctuating exchange rate.

• Low-risk investment in a volatile market Arbitrage mutual funds thrive on the uncertainty of market conditions. As prices fluctuate due to market volatility, these funds capitalize on the rising differential between the cash and futures markets.
  Moreover, these short-term investments are typically low-risk since they engage in simultaneous buying and selling of shares to take immediate advantage of the price difference. Should there be a shortage of arbitrage opportunities, these funds balance the risk by adding stable debt securities to the portfolio.
• Tax-efficient investment Considering arbitrage funds primarily invest in equities and equity-related securities -- enjoying up to 65% exposure -- they are treated like equity funds and taxed accordingly. If you stay invested for more than a year, your gains will be considered long-term capital gains (LTCG) and will be completely tax-free.

However, short-term capital gains (STCG) are taxed at 15%, and LTCG exceeding Rs.1 lakh are taxed at 10%, without the benefit of indexation.

• Fluctuating performance While these funds may generate profit in a volatile market, their performance is quite the opposite in a stable market. There is no major price difference between the cash and futures markets, considering stock prices remain largely unaffected under stable market conditions. Therefore, there’s little margin to gain from. This can lead to negative or low returns.
• High investment expense Arbitrage funds charge an annual fee, called the expense ratio, for fund management. Since these funds are involved in frequent trading, they incur heavy transaction costs, something that can cause the expense ratio to shoot up.

Moreover, investors may also have to bear a heavy exit load that is levied to discourage early withdrawal. These costs can result in a substantial increase in the expense ratio while diminishing gains in the process. To Sum up Like equity funds, arbitrage funds are tax-efficient while having the ability to generate sizeable returns in volatile market conditions. These funds are generally suited for conservative investors with a low-risk appetite and a short investment horizon.Carefully evaluate your wealth creation goals, risk tolerance and investment horizon before proceeding with an investment in arbitrage mutual funds.

The information contained herein is generic in nature and is meant for educational purposes only. Nothing here is to be construed as an investment or financial or taxation advice nor to be considered as an invitation or solicitation or advertisement for any financial product. Readers are advised to exercise discretion and should seek independent professional advice prior to making any investment decision in relation to any financial product. Aditya Birla Capital Group is not liable for any decision arising out of the use of this information.