What are arbitrage funds? When are these funds appropriate for you?

In the last couple of years, one category among the mutual funds has gained popularity – the arbitrage funds. It is important to understand what these funds are, how they work and what purpose these serve. One must also understand the risks involved in these funds. Click here to read my article published in Mid-day Gujarati edition.

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The English translation of the article is as under:

What are arbitrage funds? When are these funds appropriate for you?

In the last couple of years, one category among the mutual funds has gained popularity – the arbitrage funds. It is important to understand what these funds are, how they work and what purpose these serve. One must also understand the risks involved in these funds.

We covered this category in our column on February 6, 2017 with proper example. However, we feel that there are a few misconceptions around this category that need to be clarified, especially looking at the amount of money getting parked in these funds. Many consider this as safe as liquid funds, with the benefit of lower (or zero) taxation.

Arbitrage is a strategy to generate returns due to the price difference between two different markets for the same (or similar) securities. This often happens between the cash segment and futures segment of the stock markets, on account of what is technically known as the “cost of carry”. This “cost of carry” is akin to interest charged for short term borrowing.

However, since the money is invested in stocks (at least 65% of the scheme’s corpus), the fund is treated as “equity oriented fund” according to the Income Tax Act. This means the dividend is tax exempt in the hands of the investor, as well as exempt from the dividend distribution tax. Capital gains are tax-exempt, if the holding period is more than one year. Even when the capital gains are booked for a holding period of less than a year, the same is taxed at a lower rate of 15% and not clubbed with the income.

This tax arbitrage is drawing a lot of money towards these funds. However, it is important to understand the investment before getting on to the discussion of taxation. The investment theory must precede considerations of tax and the investment theory would help one analyse the risk-reward trade-off.

First of all, let us make one point clear: as per the classification for purposes of income taxes, arbitrage funds may be classified as equity-oriented funds, but in terms of investment theory, these are alternatives of liquid funds. Hence, please do not expect returns in line with equity funds. These funds can generate investment returns very similar to those generated by liquid funds.

At the same time, while liquid funds invest in money markets and debt markets; arbitrage funds exploit arbitrage opportunities between two different segments within the equity markets.

Pure arbitrage is considered to be an almost zero risk strategy, since the prices converge on expiry of the futures contract. However, there is a possibility that the spreads widen before the contract expires. In such a case, there could be negative returns, temporarily. One must be aware of this.

Such short term negative returns may coincide with your parking horizon and thus, you may end up with very low or even negative returns, if you have parked money for very short periods of time. This only means that one should not treat arbitrage funds as a total replacement of liquid funds, but use these only when the time horizon is slightly long, say at least one month.

In spite of the risk highlighted, the arbitrage fund could be a good place to park your fund and enjoy the reduced taxation.

-       Amit Trivedi