Arbitrage Funds: Meaning, Advantages

What are arbitrage funds?

Before we know what arbitrage funds are, let us dig down to see the meaning of arbitrage.

What is the meaning of arbitrage?

Arbitrage means simultaneous buying and selling security in two different markets to take advantage of the price difference between the two market segments.

For example, a stock X is trading at Rs 100 on NSE and Rs 110 at the same time on BSE. In such a scenario, what we can do is, we can buy it at Rs 100 on NSE and sell it at Rs 110 on BSE and can earn a risk-free profit of Rs 10. The profit is risk-free because we are buying and selling the stock simultaneously, and there is no holding of the stock.

This idea may look good in theory, but practically it does not happen like this. So instead, the fund manager does typically another arbitraging, which is discussed below.

There are two types of market. One is called the cash market or the spot market, where we usually buy and sell stocks, and the other is the futures or derivatives market which deals with the future price of a stock.

Let’s say stock X is trading at Rs 100 in the cash market and Rs 110 at the same time on a derivatives market. In such a scenario, the fund manager seizes this opportunity, buys n number of X stocks in the cash market, and simultaneously sells them on the derivatives market. The difference of Rs 10 will be the profit. This is a typical example of an arbitrage opportunity, and this is how arbitrage funds make profits.

Another arbitrage opportunity is there, called cash and carry arbitrage, where we buy the stocks in the cash market and sell the stocks in the F&O market and hold it till expiry. There may be three possible conditions on the day of expiry, i.e., the stock price either go up or down or remain flat. Let’s see what happens under the three possible conditions.

Here, we see that by buying the stock in the cash market and selling in the F&O market, we get the same profit irrespective of the price movement of the security as we know on the day of expiry of the F&O contract, both the prices in cash and the F&O segment converge.

Asset Allocation pattern of Arbitrage funds

Under normal market conditions or high spreads, arbitrage funds invest 65-100% of their total assets in equity and equity-related instruments. The remaining 0-35% invested in FDs, debt instruments, money market instruments, or in units of debt mutual funds.

When the spreads dip down, and there are no arbitrage opportunities, the allocation pattern is expected to be 0-65% in equity and equity-related instruments and 35-100% in non-equity and non-equity related instruments. This is because the margin money requirement for the derivative exposure is mostly held in the form of term deposits, cash or cash equivalents.

Arbitrage may look like hybrid funds, but essentially, an arbitrage fund is purely an equity fund by nature or construct of the fund because, as per the asset allocation strategy of an arbitrage fund, 65-75% has to be done in arbitrage trade and 15-25% has to be kept in margin money.

We cannot expect returns of arbitrage funds like ordinary equity funds. Returns would be proportionate to the price difference only. However, arbitrage funds generally give returns close to money market mutual funds. We can expect somewhere around 5-6%. Since the portfolio is hedged, risk and returns are relatively low.

Which is better Liquid fund or Arbitrage fund?

Both these funds have their own pros and cons. It depends on the investor whether he wants to invest in liquid funds or arbitrage funds after considering the investment horizon and post-tax returns.

Liquid funds are safer in comparison to arbitrage funds, as it invests mainly in debt-related instruments. At the same time, arbitrage funds are riskier as the investment returns are dependent on market volatility. On the other hand, the fund managers get ample arbitrage opportunities during a bullish market.

If you are an investor looking for tax-efficient returns, no directional exposure to equity, low volatility in returns, and most importantly, using market differences to your advantage. In that case, Arbitrage funds may be just exactly what you are looking for.

Taxation

Arbitrage funds are taxed as equity funds. If your investment duration is less than a year, your returns would be taxed at 15%, and if your investment duration is more than a year, your returns above Rs 1 lakh rupees would be taxed at 10%. This is because of long-term capital gains tax being imposed on equities effective from 01 April 2018.

If your investment time frame is between one and three years, arbitrage works better than a liquid fund because it will only be subject to a 10% tax rate. In the case of a liquid fund, all your gains will be added to your income if you are in a higher tax bracket, i.e., 20% or 30%.

In the case of liquid funds, if you redeem your investments within three years, your returns would be subject to tax according to your tax slab. On the other hand, if you redeem your investments after three years, your returns would be taxed at 20% but after indexation.

Post-tax returns

Let us now concentrate on the post-tax returns both these kinds of funds can generate for us where our investment duration is less than one year.

If you fall in the 5% tax bracket, liquid funds would be a better investment vehicle as arbitrage fund returns would be taxed at a higher rate that is 15 %.

If you fall in the 20% tax bracket, both these kinds of funds will generate similar post-tax returns. Now you might say that returns in the case of arbitrage funds would be taxed at 15%, which is lower than my own tax bracket but based upon the data of the past 10 years, it is seen that liquid funds generate half a per cent more returns than arbitrage funds. But yes, if there are more arbitrage opportunities seen in the market in the future, arbitrage funds might generate better post-tax returns.

If you fall in the 30% tax bracket, go for arbitrage funds as returns in case of arbitrage funds are taxed at 15%, which is far below your own tax bracket.

Arbitrage funds and liquid funds are good for an investment duration lesser than a year. Both these kinds of funds generate very similar returns, but the taxation of both these kinds of funds is different. And so, one has to think from a post-tax returns perspective whether to go for arbitrage funds or liquid funds in the short term.

Why invest in Arbitrage funds?

• Lower risk– The equity portfolio is completely hedged; hence, the fund will have minimal risk.
• Low volatile returns– Simultaneous trades in the same security across exchanges/ platform eliminates risks of significant price movements.
• Better post-tax returns– Being classified as an equity scheme, it enjoys a tax advantage over debt/money market schemes.
• Alternative to debt funds– As arbitrage funds can provide stable, moderate returns, they can be considered an alternative to debt-oriented mutual funds.
• Opportunity across market scenarios– Arbitrage funds have provided stable returns during bull and bear phases and perform better in volatile phases.

Conclusion

Arbitrage funds are not a long-term wealth creation tool and should be used whenever your investment duration is less than one year. You could use these funds as a parking fund whenever you have a lump sum availability till you decide what to do with your lump sum. Returns generated in the case of arbitrage funds seem risk-free but depend on the arbitrage opportunities available in the market.

In the case of arbitrage funds, you are not investing by looking into the fundamentals of a stock. So, the investments here are entirely free from the risk associated with equity investment. But here, you are making gains only from the price difference of an asset in different markets.