What are Arbitrage Funds?

By Ravi Samalad |  31-05-22 | 

Arbitrage funds are gaining traction among investors looking for a more tax-efficient alternative to Liquid Funds. The recent fund flows into this category bear testimony to this trend. Arbitrage Funds received net inflows worth Rs 4,093 crore in April 2022. In CY 2021, this category received net inflows worth Rs 42,287 crore.

How do they function?

Arbitrage Funds generate returns by exploiting mispriced opportunities between spot and futures prices in cash and derivative markets. Arbitrage opportunities can exist in the same stock between different exchanges or between a security and its futures price.

Suppose stock X is trading at Rs 100 on BSE and Rs 101 on NSE, the fund manager would simultaneously buy it on BSE and sell it on NSE at Rs 101, making a profit of Rs 1. Similarly, the fund manager can buy a stock at a spot price of Rs 1,000 in the cash market and simultaneously sell it at Rs 1,002 in the futures market, locking in a profit of Rs 2 over the duration of the contract.

On the date of expiry, if the price differential between the spot and futures position of the subsequent month's maturity still exists, fund managers roll over the futures position and hold onto the position in the spot market.

By buying in the cash market and selling in the Futures and Options market, fund managers lock in profits irrespective of the price movement of the security.

In some instances, fund managers may unwind both the spot and the future position before the expiry of the current-month future for generating higher returns or to meet redemptions.

Performance

Over a one-year trailing period as of May 27, 2022, Arbitrage Funds have delivered in the range of 2.80% to 4.97% in the case of direct plans. On the other hand, Liquid Funds have delivered in the range of 2.57% to 4.05% during the same period.  

Exit Load

Arbitrage Funds levy exit load which could be nil (for redemption of up to 10% of units before 30 days) or 0.25% if the money is redeemed before seven to 30 days (differs across funds).

Total Expense Ratio

Depending on the scheme assets under management, these funds can charge anywhere between 0.16% to 0.60% under direct plans. Regular plans can charge anywhere between 0.80% to 1.50%.

Taxation

Arbitrage Funds are taxed as equity funds.

Equity Funds

Short Term Capital Gains Tax

  • 15% (excluding cess and surcharge) if sold within one year

Long Term Capital Gains Tax

  • Tax free on gains of up to Rs 1 lakh if sold after one year. 10% tax on gains exceeding Rs 1 lakh

Debt Funds

  • Short term capital gains are taxed at slab rate as per the individual’s tax bracket.
  • Long Term capital gain tax at 20% with indexation benefit

How to use Arbitrage Funds

Tax-free withdrawal

“Arbitrage Funds are used mainly for their tax advantage over debt funds. I recommend Arbitrage Funds as a debt part of the client’s long-term goals. They are not an alternative to Liquid Fund or Short Term Funds and must not be used for short-term goals. It should be used as part of debt allocation, where we can use tax-free withdrawal (up to Rs 1 lakh) for rebalancing the portfolio,” says Bengaluru-based Registered Investment Adviser (RIA) Basavaraj Tonagatti.

Alternative to liquid surplus in the bank

“Arbitrage Fund is an alternative to liquid surplus in the bank.  It is taxed like an equity fund which is much lower compared to taxation on interest income. Hence it will always be advisable to keep surplus cash in Arbitrage Funds,” says Vinod Jain, founder of Jain Investment.

Returns could improve

“Typically, investing in Arbitrage Funds doesn't have much to do with where markets are trading - bullish or bearish. Arbitrage Funds are largely meant for parking short-term surpluses. As they run fully hedged equity portfolios, these strategies are market neutral and can be considered as an option to Liquid or Ultra Short Term Funds since they are more tax efficient. As short-term interest rates move up in line with monetary policy tightening, yields and hence returns on Liquid & Ultra-Short Term Funds should move up. Similarly, returns on Arbitrage Funds track short term interest rates and these should also see improvement,” says Dhaval Kapadia, Director – Portfolio Specialist, Morningstar Investment Adviser India.

To sum up, Arbitrage Funds can offer superior post-tax returns in comparison to low-risk debt funds with low risk and low volatility.

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