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

Arbitrage funds - for short term parking of funds

Please click on the link here to read the article, published in Mid-day Gujarati, Mumbai edition on 6th February, 2017

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The English translation is as under:

In the last few years, one of the mutual fund categories has become quite popular – especially among individual investors intending to park money for short periods of time. This category is known as “arbitrage funds”.

As such, the name does not indicate anything, especially for the uninitiated investors or someone who is less familiar. However, these funds are among the safer funds in that they do behave almost like liquid funds. As mentioned earlier, these funds may be considered for parking money for short periods like a month or a quarter or so.

Let us understand how these funds work.

The term arbitrage means “simultaneous buying and selling of same securities, commodities, or foreign exchange in different markets to profit from unequal prices.” Arbitrage requires two separate markets and a price difference in these markets for the same security. Since one is simultaneously buying the cheaper one and selling the costlier one, this is a profit-making opportunity without involving any risk.

In reality, there could be transaction costs involved in both buying as well as selling. These costs need to be adjusted before arriving at the profit number. Such anomalies do exist at times and many players take advantage of the same.

Lest us elaborate on this in the Indian context through the example of arbitrage opportunities in stock markets.

On 3^rd February, Axis Bank stock closed at Rs. 489.90 on the National Stock Exchange and at Rs. 489.65 on the Bombay Stock Exchange (both prices are taken from the cash market segment). If someone could buy on BSE and sell on NSE simultaneously at the closing price, there was a net profit of Rs. 0.25 per share, assuming the transaction costs to be zero. (For the purpose of this discussion and example, we would assume the transaction costs to be zero. For simplicity, we are also assuming that one has to deliver the shares at the NSE only after receiving the same from the BSE.)

Since both purchase and sale happened simultaneously, there is no risk involved – whatever happens to the price of the stock. The profit of Rs. 0.25 per share on a share price of Rs. 489.65 translates into a profit of 0.051% for a day, or 18.64% per year. Please understand that this calculation is based on the assumption that the transaction costs are zero. Once you adjust for the costs, there is no profit opportunity left.

On the other hand, there is generally a price difference between the cash market and the derivatives market. Taking the example of Axis Bank once again, on the BSE cash market segment, the closing price was Rs. 489.65 and that for Axis Bank futures (expiring on 23^rd February) was Rs. 491.30. This meant that the futures price is higher than the cash market price by Rs. 1.65 per share. Someone can profit from this opportunity (once again, this calculation is without factoring the transaction costs) by buying the shares in the cash market segment and selling the futures. The futures contract would automatically expire on 23^rd February, whereas the shares bought on cash market must be sold on the same day. That means, the investor would be investing Rs. 489.65 per share for 20 days and earn a profit of Rs. 1.65 for the same. This translates into an annual profit of 6.15%.

If during the 20 day period, share prices go up, one would profit on the cash market – the shares bought, whereas lose on the futures market – futures contracts sole. If the prices go down, it would be reverse, i.e. loss in the cash market segment and profit in the futures market. Thus, theoretically, one has pocketed the annualized profit of 6.15%, irrespective to what happens to the price thereafter. This is why such trade is considered risk-free.

Arbitrage funds take the advantage of such opportunities.

At the same time, as we have seen in the numbers, most of the time, the profit is in the range of the returns liquid funds can generate.

Since these funds invest in the stock market, such funds may get classified as equity funds for the purpose of income tax. That makes these funds very attractive as compared to liquid funds.

- Amit Trivedi