WHAT IS ARBITRAGE FUND?

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 have lost some of their attraction too. 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 which invest approximately 65% of the corpus in equity-related instruments.

The 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.

WHAT IS ARBITRAGE FUND – A DEFINITION?

An arbitrage fund is a type of mutual fund which earns profits through the purchase and sale of securities on different exchanges. However, unlike the regular equity trade in which the stocks are purchased when the prices fall and are sold in the future when prices rise; an arbitrage fund buys the stock in the cash market and sells the interest in the futures market, simultaneously. Since the difference between stock prices and that of futures contracts are typically marginal, arbitrage funds are required to execute a huge number of trades every year so as to make any substantial gains. Arbitrage funds are also those funds that leverage the inefficiencies and the volatility of the market to generate profits for investors in the medium term. Let us find out how.

Arbitrage Funds

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 security in the futures market. The difference between the prices of 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 ₹90 on December 15, 2017. Simultaneously the fund manager sells 1000 futures for December 2017 expiry X at ₹95. This locks the selling price for X at ₹95 while purchasing it at ₹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 ₹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.

FEATURES OF ARBITRAGE FUNDS

Now that we have a fair idea of what is arbitrage fund, let us take a look at some of its basic features. They are as under:

• The risk factor: Arbitrage funds come free of any counterparty risks since trades are typically carried out on the stock exchanges. There is also no apparent major risk exposure when these funds are traded for sale and purchase by fund managers in both, the cash and futures market. This makes arbitrage funds much less risky as opposed to other diversified funds.

• You may or may not earn high returns: Fund managers trading in arbitrage funds typically attempt to generate high returns with the help of price differentials. In the past few years, these funds have provided returns to the tunes of 7% – 8% over a period of 5-10 years. While arbitrage funds can probably help an investor earn high returns, the investor should also consider the fact that there is no real guarantee that he will always earn returns at all.

• The cost of the fund: Every investor must consider the cost aspect when it comes to making investments. This also applies to arbitrage funds. Arbitrage funds charge an annual fee comprising a certain percentage of the assets of the fund. This includes the fee charges of the fund manager as well as the management charges. Investors must always remember the nature of arbitrage funds i.e. they demand frequent trading. As a result, the fund attracts higher expenses. It also has a high turnover ratio. Furthermore, these funds levy an exit load that further eats up the investor’s returns.

• The ideal investment tenure: Arbitrage funds are suitable for investors who prefer to stay invested for a medium, moderate term of about three to five years. Returns accrued on these funds are generally dependent on market volatility to a great extent. As a result, it is better to invest in arbitrage funds with a lump sum amount as opposed to SIP (systematic investment plan) investments.

• A few other important features of arbitrage funds are that they offer:

• Equity Taxation Benefit – this simply means that after one year of investments in arbitrage funds, the returns accrued are tax-free.

• Comparable returns – Return accrued from arbitrage fund investments may well be compared to those accrued from debt or liquid funds.

• Tax-free dividends – Since arbitrage funds are considered as equity funds, the dividends earned are tax-free. Like with debt or liquid funds, the Dividend Distribution Tax is not applicable on arbitrage 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 the increase in redemption or other factors.

Having understood what is arbitrage fund, 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.

BENEFITS OF ARBITRAGE FUNDS

Although we have pointed out the safety features and the risk factors of arbitrage funds, let’s take a detailed look at their benefits. They are as under:

• Arbitrage funds are low risk funds: One of the greatest benefits of these funds is that they are low-risk funds. There is virtually no risk involved in trading these funds in the longer-term since each security is purchased and sold simultaneously. Additionally, a part of the arbitrage fund capital is also invested in debt securities, which are generally regarded as highly stable investment instruments. In the event that there appears to be a shortage of funds that are profitable, more funds are invested in debt securities to ride out the risk factor. Since this investment technique can reduce the investor’s risk, arbitrage funds are considered highly appealing by most investors with low to medium risk appetites.

• Arbitrage funds flourish when the market is volatile: Another major benefit of arbitrage funds is that they are probably the only low-risk securities which actually flourish during highly volatile market conditions. This is attributed to the fact that volatility, naturally, makes investors feel uncertain of their investments. The variances between the cash and futures market are overstated. The main feature of a highly stable market is that individual stock prices do not exhibit much change. If there aren’t any apparent bullish on bearish market trends for either continuing or reversing an investment, investors do not have any reason to believe that the prices of a particular stock will be quite different from its current price, in the near future. Since risk and volatility go together, one must remember that they cannot have high gains or high losses without the other. This makes arbitrage funds a great choice for cautious investors looking to continue reaping benefits of volatile market conditions, without taking on much risk.

• They balance out your investment: Arbitrage funds primarily invest in equities. As a result, they are generally considered balanced funds since they invest in both equity and debt. They are hence taxed as equity funds because, on an average, 65% of an investor’s portfolio is represented by long equity. If an investor holds his shares in arbitrage funds for over a year, then he is taxed on any gains he receives at the capital gains rate. The capital gains rate, however, is much lower as compared to the regular income tax rate.

DISADVANTAGES OF INVESTING IN ARBITRAGE FUNDS

When we talk about what is arbitrage fund and its benefits, it is only fitting to shed light on its disadvantages as well.

• They are not highly reliable: One of the greatest drawbacks of arbitrage funds is that they are, at best, mediocre when it comes to reliability. As we have stated above, investors cannot really profit from these funds when the market is stable. In the event that there aren’t sufficient arbitrage trades available that can be deemed profitable, the fund essentially becomes a bond fund, even if it is for a temporary period of time. This situation may reduce the profitability of the fund on a drastic scale. As a result, equity funds, which are actively managed, can outperform arbitrage funds in the long term.

• The expense ratio is high: As we mentioned in the features, arbitrage funds require a higher number of trades for successful arbitraging. As a result, the expense ratio of these funds can be potentially high. While these funds can prove to be a very lucrative investment when the market volatility increases, one cannot simply invest in them, considering the volatility factor. This average reliability along with the high expenses, do not make arbitrage funds the most lucrative investment vehicle. Investors should, therefore, ensure that arbitrage funds are not the only investment instruments in their portfolio.

• The payoff is unpredictable: Despite the fact that arbitrage funds are considerably, low-risk investments, one cannot predict the payoff. Depending upon the investor’s specific investment aim and risk appetite, money-market instruments, long-term stocks, and bonds may prove to be stable investment options which provide consistent annual income and steady growth as opposed to arbitrage funds or equity funds that are managed aggressively.

RISK FACTORS OF INVESTING IN ARBITRAGE FUNDS

Now, let’s take a gander at some of the risks associated with investing in an arbitrage fund.

• Arbitrage risk: Arbitrage funds are not free of risks. There is a certain amount of risk associated with the fund as well. If the investor does not spot the right arbitraging opportunity and if he takes his time to think about it, the opportunity can slip from his fingers almost immediately. This is attributed to the fact that the price difference may cease to exist, by the time the investor actually realises that there is a difference in the price. As such, the opportunity to arbitrage can pass by without the investor realising it. This is very tricky because the investor must identify the arbitraging opportunity and take action even before the actual opportunity for arbitraging arrives.

• Liquidity risk: Unlike liquid funds that can be redeemed almost immediately, it takes an investor up to 3 days to redeem his arbitrage fund. The fund amount is credited into the investor’s account after 3 days as opposed to liquid funds which are credited into his account in 24 hours. The redemption turnaround time of T+3 days is set since the arbitrage fund is classified as equity, as a result of the taxation advantage. This late credit simply means that the investor loses float for 2 interim days.

• Exit load risk: Another risk associated with arbitrage funds is that they come with an exit load of 60-90 days. Hence, any funds, which are certainly there for 3 months to a year, may be invested in arbitrage funds over liquid funds.

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