Arbitrage Mutual Funds: Meaning, Benefits & Tax Advantages

Investing in a volatile market can be risky, but Arbitrage mutual funds are ones that work well in an unstable market and still offer lucrative returns. These funds appeal to investors who want to profit from a volatile market without taking a risk.Arbitrage funds are ideal for low-risk investors who want to earn maximum returns from the volatile market. It is a type of equity-oriented hybrid fund that involves buying and selling the same security in different markets to benefit from the opportunity that arises due to the mispricing of the security.It invests both in equity and debt financial instruments, but the exposure of equity is high. Unlike a regular fund where investors buy stocks and sell them when the price increases, the arbitrage fund works by purchasing stocks from the cash market and selling them in the futures market.

Low Risks

Arbitrage funds carry low risk as compared to debt funds. Thus if you are searching for gains from equity fund with low risk involved as that of debt funds then arbitrage funds make a goop option.

Suits The Volatile Market

Usually funds may give negative returns and become unpredictable during highly unstable market. Though arbitrage mutual fund is one option that is exception in this case. Here the gains and market volatility go hand-in-hand.

As per the new regulation introduced during the Budget 2014-15, the holding period of long-term capital gains or LTCG tax in debt funds was extended from 12 months to 36 months, making the liquid fund less attractive. On the equity front, there was no change in the long-term capital gains tax. This is why many investors started parking their money in Arbitrage mutual funds after 2014, as these are treated as equity funds for taxation purposes.Later on, when the government introduced a 10% tax on LTCG and the dividend earned from the equity funds during Budget 2018-19, many investors decided to move away from arbitrage funds. Post-March 2018, Arbitrage mutual funds' dividend plans witnessed a huge outflow, and investors once again started investing the fund.

In terms of tax efficiency, an arbitrage fund is a great option for investors as capital gain tax rates are lower. Thus, arbitrage mutual funds have a tax advantage. Investors can get superior tax advantage as compared to liquid and short-term funds.Those who fall in the tax bracket of 20% to 30%, they can invest their money in this short-term fund for a period of six months to one year. If the arbitrage funds are invested for up to 45 days, the returns can be negative.

Arbitrage mutual fund derives good returns when the market sentiment is bullish, as this is the time when equities have an upward trend. In case there is a bearish sentiment in the market, the returns are lower.Over the past few years, the fund has generated return at the rate of 7.5% annually, which is noteworthy compared to liquid mutual funds that generate a return at the rate of 6.6% annually. The Arbitrage Funds is definitely an attractive option for low-risk tolerance investors.

If you want to invest in a volatile market with the hope of gaining maximum returns, an arbitrage mutual fund is an ideal investment option. These funds are suitable for investors who have a high-income tax bracket and a short-term investment horizon. It is a safe investment option for risk-averse investors who want to park their surplus cash in a fund that leverages the market inefficiencies to derive maximum returns.

The simultaneous purchase and sale of the same asset in multiple marketplaces are known as arbitrage. The goal is to make money from minute variations in the asset's quoted price.
When a security's price differs between markets, you can make a profit without taking any risks. You need to purchase it in the market where the price is low while selling it in the marketplace where the price is high.The purchase and sell transactions must be carried out simultaneously to protect you from the danger of price volatility. As arbitrageurs want to gain benefits without taking risks, all their buy & sell positions are fully (100%) hedged.

Arbitrage funds use hybrid mutual fund strategies that leverage pricing variations among the same underlying assets in various capital market segments to generate arbitrage returns. Debt & money market products are additional investing options.It exploits the price discrepancies between current & future securities to maximize gains. Shares are purchased by the fund or asset manager on the open market and then sold on futures as well as derivatives markets. Your return is the difference between the cost & the selling price.

Here is an example for you to comprehendthe functioning of arbitrage funds in the simplest terms.
Take into account the fact that the share equity of company XYZ is currently trading at Rs 1,220/- on the cash market and at Rs. 1,235 on the futures market. The fund manager pays Rs. 1,220 for XYZ shares on the open market and prepares to sell them for Rs. 1,235 via a futures contract. When the prices overlap at the end of the month, your fund manager or the asset manager will sell the shares in the futures market, earning a risk-free gain of Rs. 15 per share.On the other side, if the fund manager or asset manager anticipates a future price fall, he/she will enter a long contract in the futures market. He/she would short-sell the shares on the open market at Rs. 1,235. He/she spends Rs 1,220 on shares in the futures market to cover his position towards expiry, making a profit of Rs. 15. Another option is for the fund manager to purchase an equity share on the NSE for Rs. 100 and sell it on the BSE for Rs. 120 in order to generate a risk-free return .

Arbitrage funds profit from low-risk buy & sell opportunities in the futures & cash markets. Their risk level is similar to that of an all-debt fund. These funds are appropriate for investors who desire to invest in the equities market but are worried about the risk involved. Risk-averse persons can safely invest their spare funds in arbitrage funds whenever the market is constantly fluctuating.

No, arbitrage funds are not tax-free. For tax purposes, these funds are regarded as equity funds. Short-term capital gains (STCG), which are taxed, are made if you hold an investment for less than a year. STCG is subject to a 15% tax.Gains will be regarded as long-term capital gains if you continue investing for more than a year (LTCG). Over Rs. 1 lakh in LTCG is subject to 10% taxation. These funds are appropriate for traditional investors in higher tax brackets to earn tax-efficient returns instead of sticking with pure debt funds.

1) Risks involved

Since trades take place on the stock exchange, no counterparty risk is associated with these funds. As with other diversified stock mutual funds, there is no vulnerability to equities, even if the asset manager is purchasing and selling shares in the futures and cash markets.Do not become too relaxed with these funds despite the easy appearance of the investment process. There won't be as many arbitrage possibilities as when more people start investing in arbitrage funds.
The difference between the prices on futures and cash markets will narrow. Thus, it will leave less money for speculators interested in arbitrage. In this situation, you might need to invest in alternative debt funds to get greater returns.

2) Return on investment

Arbitrage mutual funds are a great way to create a reasonable profit. These funds typically offer returns of 7% to 8% over five to ten years.
Arbitrage funds are a good choice if you want to generate a portfolio with the right balance of equity and debt in an unpredictable market. It is crucial to remember that arbitrage funds do not offer assured returns.

3) Investment costs

Cost plays a significant role in the evaluation of arbitrage funds. An annual fee called the expense ratio is levied by the fund. The fund manager's fee plus fund management costs are included. Arbitrage funds would entail substantial transaction fees and a high turnover ratio due to frequent trading.The fund may impose exit loads for 30 to 60 days to deter investors from selling their shares early. The fund's expenditure ratio could rise due to all these expenses. Your take-home returns are under pressure from a high expense ratio.

4) Horizon of investment

Investors with a three to five years short- to medium-term time horizon may find arbitrage funds attractive. Please keep in mind that extreme volatility significantly impacts fund results. So it makes sense to choose lump sum investments rather than systematic investment strategies (SIPs).
Liquid funds may offer higher returns than arbitrage funds if volatility is absent for the same investment period. Thus, it would be wise to choose arbitrage funds while keeping in mind the overall state of the market.

5) Financial goals

Arbitrage funds are a good choice if you've got short- to medium-term financial targets. These funds can be used to park extra money to build an emergency fund & earn higher rates than a typical savings account.Consider that you have previously invested in riskier choices like equities funds. In that instance, you might start a systematic transfer plan (STP) from the equity funds into a less risky shelter like arbitrage funds as you reach your financial objectives. This would decrease your portfolio's total risk while lowering the returns. Double-digit returns are not something you can anticipate from arbitrage funds.

For better profits and to maximize tax efficiency, you should think about investing in arbitrage funds for six months or longer. Liquid funds , on the other hand, provide higher liquidity. Investors can withdraw their money after the 7-day lock-in period without running a significant risk of losing money.

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.