Dhaval Kapadia, Director, Portfolio Specialist, Morningstar Investment Adviser (India) answers queries in The Financial Express, from where the below has been taken.
I have been advised by my relationship manager to invest in an arbitrage fund instead of parking money in a savings account. I am still not convinced. What would you advise me to do?
— Ashish Lele
Arbitrage funds as the name suggests, try to take advantage of the price differential of a stock in the cash market and the futures markets. Typically, the price of a stock in the derivatives market quotes at a premium to its price in the cash market. This allows for an arbitrage opportunity which such funds attempt to encash by buying a stock in the cash market and selling it in the futures market thereby earning the differential premium between the two prices.
In other words, in case the price of the stock was to move below its purchase price during the month, the value of the stock holding would come down but the value of the futures position would increase since the stock was sold in the futures market at a higher price, thereby setting off the loss incurred on the stock position. Eventually, the return on these positions i.e. the buy stock-sell future trade, would be tend to be equal to the premium or price differential between the stock and futures position that was locked in when the trade was undertaken.
Typically, arbitrage funds when executing these trades buy a stock and sell the one-month future contract on that stock thereby locking-in a return for a month. The spreads or differential between the cash and futures price can vary on a month-on-month basis, resulting in varying returns. This occurs due to various reasons including demand-supply scenario in the derivatives market, prevailing short term interest rates, market trend, etc. Typically, spreads (and therefore returns) tend to reduce when the demand for such positions is high and/or when interest rates are falling and vice-versa.
The tax treatment for arbitrage funds is favourable vis-à-vis debt funds, interest from savings account and other debt instruments. For taxation purposes, arbitrage funds are treated as equity, as a result, dividends and long term capital gains (units held for one year and above) are tax free whereas short term capital gains (units held for less than one year) are taxed at 15%. In terms of liquidity, arbitrage funds carry exit loads for exit up to one month or so (some funds may have loads for longer periods). Due to their return characteristics, market neutral nature and liquidity provisions, arbitrage funds are considered debt-like, acting as substitutes for savings accounts, ultra-short term and short term debt funds and are suited for a horizon of six to 12 months.
