What Is Arbitrage Funds?
Interest rates have seen a decline and most banks have reduced the savings bank (SB) accounts interest rate. Some banks may offer as less as 3% to 3.5% as the SB accounts interest rate.
Several banks have also lowered the interest rates on fixed deposits (FDs) to about 6.25% per annum on a one-year deposit. With this decline in interest rates, investors like you are trying to find investment products that offer higher returns.
Some may consider debt funds to be an alternative investment instrument. However, since the government changed the long-term holding period, these funds too have lost some of their attraction. Debt funds are no longer considered a good investment option at least for the short-term.
A more attractive investment avenue is available through arbitrage funds. These are types of equity funds and invest approximately 65% of the corpus in equity-related instruments.
These equity mutual funds benefit from the price differences in different markets. However, these are often short-term opportunities available due to lack of information to investors.
How Do Arbitrage Funds Work?
The term arbitrage implies that the same security is acquired and sold in two different markets to gain from the price difference. Because the transactions in both markets may be in either direction, the position is hedged. Therefore, arbitrage transactions in most instances are almost risk-free.
Fund managers evaluate the price difference of the security in the futures and spot markets. If the price is higher in the futures market, the fund manager buys the security in the spot market. At the same time, he will sell the same quantity of the security in the futures market. The difference between the prices of the security in both the markets is the fund manager’s gains.
Here is an example to help you understand better. Assume that ABC fund acquires 1000 shares of X for INR 90 on December 15, 2017. Simultaneously the fund manager sells 1000 futures for December 2017 expiry X at INR 95. This locks the selling price for X at INR 95 while purchasing it at INR 90 in the spot market. The fund has hedged its position in X. If the fund manager holds this position until the expiry date, the fund is able to earn INR 5000 as profits irrespective of the stock price of X on the expiry date.
What Is The Difference Between Debt Funds And Arbitrage Funds?
1. Taxes Applicable On Redemption Of Mutual Funds
Under the current policy, gains on non-equity mutual fund schemes that are redeemed before 36 months from the date of investment are added to your annual income. The short-term capital gains are taxed as per your income tax bracket. Therefore, if you are in the highest bracket, you may pay over 30% (including tax and surcharge). Furthermore, long-term capital gains are taxable at a rate of 20% post-indexation. Therefore, if you want to invest money for the short-term, these high tax rates will reduce your actual gains.
Because arbitrage schemes invest a majority of its corpus in equities, the long-term capital gains made when you stay invested for at least one year are tax-free. Additionally, short-term capital gains in case you exit before 12 months are taxable at a flat rate of 15%. Therefore, arbitrage schemes offer higher returns and tax benefits when you want to invest for the short-term.
2. Dividend Distribution Tax
Dividends earned on arbitrage schemes are not liable to dividend distribution tax. However, interest earned on debt funds is subject to tax. Therefore, the effective returns on investment are higher for arbitrage schemes when compared to debt funds.
Are Arbitrage Funds Safe?
In most cases, arbitrage funds have very low risks. This is because the fund managers assume the neutral position by purchasing in the spot market and selling the same asset in the futures market. The market volatility does not pose any risk to the fund’s investment position. Arbitrage opportunities are available only during uncertain and unstable market conditions. On the other hand if you want to invest with greater liquidity during uncertain market trends, you can try out the SIP way.
However, there is some risk in case the fund needs to liquidate the investment before the expiry date of the futures contract. This may be necessary because of increase in redemption or other factors.
Having understood what arbitrage funds are, it is important you assess your requirements and tax liability before making an investment decision. Furthermore, evaluate the different available options to make the right choices.
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