Arbitrage Funds

What are Arbitrage Funds?

We are aware that the equity market is highly volatile. However, masters of the trade capitalize on this volatility to leverage and use them to spin investment opportunities for them. Arbitrage funds focus on leveraging this market volatility. They function on buying and selling securities, commodities, or currencies simultaneously from different diverse markets to derive benefits from the difference in their price points at various vends.

In simpler words, an arbitrage fund is an equity fund that invests in equity derivative instruments, like stocks, and plays on the price advantage between two market segments.

Who Should Invest in Arbitrage Funds?

Arbitrage funds are balanced or hybrid funds as they invest in both debt and equity, but their primary investments are in equities. Even though Arbitrage funds are relatively low-risk funds, their payoffs, or arbitrage fund returns, are unpredictable. They are another variant of mutual funds. They function on the principle of purchasing stock in the cash market and simultaneously selling off that interest in the futures market.

Hence, people who should ideally invest in these funds are:

  • Those with cash surplus want to make extra earnings instead of keeping them idle in their savings account and earning a very small interest rate.
  • Anyone looking for a short to medium-term investment strategy should go in for investing in Arbitrage funds.
  • The term period of 3 to 5 years is ideal for investing in such funds. Hence, those with extra funds and who do not have immediate cash requirements can hold on to them for some time.
  • Those who desire to profit from volatile markets yet do not want to get involved and invest in high-risk sectors.
  • These funds charge exit loads. Hence, keeping this in mind, arbitrage funds should be considered for investments only by those who would retain their money in them for at least 3 to 6 months.
  • These funds are good for people under the higher income bracket, as they can use their surplus funds to invest and earn profits on them.

Taxability of Arbitrage Funds

Since arbitrage funds involve 65% of their holding in equities, they are categorized as equity funds and are taxed accordingly. This way, these funds earn the advantage of zero taxability on long-term capital gains (LTCG). If the funds are held on for more than a year, they fall under the category of LTCG and are completely tax-free.

The taxation policies for arbitrage funds are:

  • For an investment period of less than a year, for any amount of returns gained, the nature of tax would be considered as short-term capital gains (STCG), and the tax rate applicable would be 15%.
  • When the investment period is more than a year, and the returns gained are less than a lakh, the tax would be considered long-term capital gains (LTCG), and it would be fully exempt from tax. And if the returns gained are more than a lakh, the tax would be considered long-term capital gains (LTCG), and the applicable tax rate would be 10% without indexation benefits.

However, the tax rates applicable on arbitrage funds, as of date, are lower in comparison to any other debt funds.

Risks Involved With Arbitrage Funds

Arbitrage funds are hybrid funds, primarily investing in debt funds that yield low returns, differentiating them from managed equity mutual funds. You need to keep the following points in mind before going ahead and investing in them.

  • Ensure your financial goals align with the fund’s future objectives. Such funds are best suited for short to medium-term goals. Hence, instead of keeping their excess funds idle in a savings account, they can invest them in arbitrage funds to earn extra returns.
  • Various costs like entry load, exit load, expense ratio, etc., come attached when investing in arbitrage funds which should be calculated beforehand as frequent trading may lead to high transaction costs and a substantial turnover ratio.
  • Whichever fund you choose to invest in, keep an eye on its performance in both bearish and bullish market conditions. This way, you would select one of the best arbitrage funds and the most reliable one in a volatile market scenario.
  • Tax on arbitrage mutual funds is the same as equity funds, considering this factor as arbitrage funds are mediocre reliability funds.

Advantage of Arbitrage Mutual Funds

Arbitrage funds are good when you expect to get moderate returns from your investments. The advantages of investing in these funds are:

Low on Risk

Arbitrage funds are low-risk securities. Since these funds buy and sell securities frequently, there are no long-term risks involved.

Suitable for the Volatile Market

Even in a highly volatile market, arbitrage funds flourish well. Through fast buying and selling of stocks in different markets, these funds use the volatility feature to their advantage to generate returns for their investors.

Taxed Similar to Equity Funds

Equities constitute around 65% of the arbitrage funds and hence are taxed similarly to them. Therefore, they yield a higher tax advantage rate on returns over other funds.