Should You Invest In Arbitrage Funds?

What are arbitrage funds? As per Investopedia, the definition of Arbitrage is “The simultaneous purchase and sale of an asset to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms. Arbitrage exists as a result of market inefficiencies”.

How do arbitrage funds work?

To quote an example, If the price of a particular stock is quoting in BSE for Rs. 95 and the same stock is available for purchase on NSE for Rs. 95.75, then a trader can purchase the stock on BSE and sell the same in NSE, thereby making a profit of Rs. 0.75 per share. Similar trades.

Are arbitrage funds safe?

Arbitrage funds leverage the price differential in the cash and derivatives market to generate returns. The returns are dependent on the volatility of the asset. These funds do not invest the entire corpus in arbitrage opportunities but maintain a decent allocation roughly around 30 to 40% in debt securities too thereby making it a hybrid fund in nature. These funds mostly try to take advantage of market inefficiencies which creates situations of price differentials of the same stock in different exchanges. To protect its downside, these funds cover their stocks positions by taking opposite calls on the futures market. A typical arbitrage fund invests about 60 to 70% of its corpus in stocks and futures while rest goes in very short term debt securities.

Read – Debt Fund Risk

Arbitrage fund vs Liquid fund

Arbitrage funds display very low volatility and in terms or nature or returns they are compared with liquid funds. Liquid funds only invest in very short term/ liquid securities and are completely different from the way Arbitrage funds are managed.

Arbitrage fund tax treatment

The biggest difference is the tax structure in these funds which has attracted a lot of short term investment money in this fund. While short or long-term capital gains in liquid funds is added to total income and taxed as per slab, Arbitrage funds enjoy tax status equal to equity funds. Any gains in arbitrage funds which are less than 1 year are taxed at a reasonable 15% while all long-term gains after 1 year are tax free.

Must Read – Mutual Funds are more tax efficient

Should I invest in arbitrage funds?

For an investor who is looking at parking funds for a period of 3 months or more, he can consider arbitrage funds, but those looking at less than 3 months should stick to liquid funds. There is a certain amount of predictability in returns in liquid funds if one considers its invested portfolio but that’s not the case with Arbitrage funds.

At times if the market volatility is low, then there might not be may opportunities available for arbitrage positions which might bring down the returns of the fund. Secondly, favourable tax benefits have attracted a great deal of investments in these funds which creates challenges for the fund manager in deploying the huge cash in various securities for which the arbitrage opportunities may not be adequate.

Arbitrage fund returns

Most Arbitrage funds have been providing an average return ranging from 6 to 7% in recent times which is lesser than most liquid funds but when one compares the taxation, Arbitrage funds return better on a post-tax basis. Investors in the higher tax bracket will benefit more due to its favourable taxation but for others in the lower tax bracket, ultra-short-term funds might work better.

ReadFirst-time investors in capital market should take Mutual Fund route

Are arbitrage funds still worth it?

With increasing investor interest and continuous flow of funds in arbitrage funds, the overall performance might come down in the future, hence one needs to be cautious and aware of these factors before investing. Extreme market events can also shake up the market positions which can impact these funds to some extent, though we haven’t seen instances of negative returns.

For the conservative investor, the liquid and ultrashort term funds might work better as they are devoid of any negative surprises (except for very very rare events) and no volatility.

Feel free to ask your questions about Arbitrage Funds in the comment section.