Arbitrage Mutual Funds: Benefits and Drawbacks

Arbitrage funds are a type of mutual fund that leverages the market volatility and generates profit from the differential price of the securities in the cash market and derivatives. Let's know more about it.

The term 'arbitrage' means buying and selling securities and other commodities simultaneously in different markets to take advantage of the price difference of the same assets in different markets. Arbitrage Funds invest in equities and generate profit by exploring the difference in the prices of units of shares in different markets.The arbitrage funds leverage the market's inefficiencies, and the profit margin depends on the volatility of the assets. These funds are mostly purchased in the cash market and sold in the futures market.Should You Consider Investing in Arbitrage Funds?Yes, you can consider having arbitrage funds in your portfolio if:

• You have a low-risk profile and are looking for exposure to equities with minimal risk. When the markets are stable, there is no big difference in the prices of the securities, and hence the opportunity for generating profits is less. But, when the market is volatile, arbitrage funds benefit from the price fluctuation, and you have better chances of earning profits.
• You want to take advantage of the unstable market conditions and take calculated risks to gain high returns.
• You are looking for a short-term to a medium-term investment opportunity to park your savings.

• Minimal Risk Arbitrage funds are known to have low-risk and ideal investment choice if you are looking to get a decent return with minimal risk. These funds, which buy and sell securities in the cash and the futures markets, are often compared to pure debt funds in terms of risk levels. So, if you are looking to get gains from equity funds with low risk as a debt fund, you can benefit from investing in arbitrage funds.
• Ideal investment during the unstable market condition Most of the funds may give negative returns, or the returns may be highly unpredictable when the market is volatile. In contrast, the Arbitrage fund is the only mutual fund that thrives in the unstable market condition. Here the returns and the volatility go hand in hand.
• Treated as equity funds for tax purposes The fund comprises of investment in equities and equity-related securities that represent an average of 65% of the fund. This is the reason why the tax implication on Arbitrage Funds are the same as equity. The tax rate is based on the holding period. So, if you hold the funds for more than a year, it will be taxed as long-term capital gains, and if the holding period is less than 12 months, then it will be taxed as short-term capital gains.

While there are many benefits of arbitrage funds, it has a few disadvantages, too, as discussed below:

• Unpredictability in Payoffs One of the significant reasons many investors refrain from having arbitrage funds in their portfolios is that they are known to have mediocre reliability. These funds do not perform well when the market is stable. During a stable market, when there are no profitable arbitrage trades available, the fund may become a bond fund , albeit temporarily. This, in turn, can have a significant impact on the fund's profitability.
• High Investment Cost There are many costs associated with the arbitrage investments, and one of the highest costs is the expense ratio or the turnover ratio. Since these funds are traded frequently, it also attracts a substantial transaction cost. Additionally, to discourage the investors from exiting the funds prematurely, the fund houses levy an exit load for 30-60 days, further increasing the expense ratio. Thus, the various costs involved reduce take-home returns.

Like any other mutual fund investment, you can invest in arbitrage funds, either online or offline. Let us look at the modes of investing in detail.

Offline Investing

If you are not confident about investing online or don't have sufficient knowledge, you may choose to invest through a broker. Investing in arbitrage funds through a broker will make you eligible to invest through the regular plans that may have high investment costs and different returns.If you wish to invest in these funds independently, you can visit any of the nearest AMC (Asset Management Company) branches, and submit the investment form along with the following documents:

• Proof of identity
• Proof of residence
• Aadhaar Card
• KYC documents
• PAN card
• Cancelled cheque
• 4-5 passport size photographs

Online Investing

If you wish to save on paying the commission or the brokerage, you may choose to invest online. Investing in arbitrage funds online is easy; it is similar to investing in any other mutual fund. You may visit the fund's official website, select the fund you wish to invest, and follow the investment steps, which typically includes filling the form, KYC compliance, and making payment.

As mentioned above, arbitrage funds are taxed as equity funds. If you hold the funds for less than one year, the returns earned will be considered short-term capital gains, and you will be liable to pay taxes at the rate of 15%. So, if you make a profit of Rs. 50,000, you must pay Rs.7,500 as tax.On the other hand, if you hold the funds for more than one year, the returns earned will be considered as long-term capital gains, and you will be liable to pay taxes at the rate of 10%. You must note that if you hold your funds for a longer period (more than 12 months), you can claim tax benefits up to Rs. 1 lakh in a year. So, if you earn a profit of Rs. 1.5 lakhs, the total tax payable would be Rs. 5000 (10% of Rs. 50,000). Final Word Just like any other investment in mutual funds, arbitrage funds are not oblivious to risk. So, it is paramount that you assess your needs well, and read the scheme related documents carefully to make an informed decision.

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.