Arbitrage Mutual Funds – What are Arbitrage Funds India | Basics, Taxation & Benefits

Ever notice a great deal on a shirt at one store, only to find it slightly cheaper online? That is a small example of arbitrage.

The arbitrage funds use similar tactics to capture profits from price differences. In this blog, we will learn about arbitrage funds and their performance. 

Overview

Arbitrage funds are a type of mutual fund that seeks to profit from price discrepancies between different markets. This is achieved by engaging in the simultaneous purchase and sale of securities in various markets, thereby seizing the price difference as a source of profit. For example, an arbitrage fund might buy a stock in the cash market and sell it simultaneously on the futures market if the futures price is higher than the cash price. This is possible due to the occasional lack of perfect alignment between the futures and cash markets, which results in transient price disparities between the two.

These funds are commonly considered a comparatively low-risk investment due to their minimal dependence on the stock market’s overarching trend.

Example

Let’s understand the workings of an Arbitrage fund with the help of an example.

Suppose a stock is trading at INR 100 in the cash market. In the futures market, the same stock might be priced at INR 105 with delivery in a month. An arbitrage fund can buy the stock in the cash market for INR 100 and simultaneously sell the same stock in the futures market for INR 105 (locking in the contract).

Upon the futures contract expiration after a month’s duration, the fund proceeds to fulfil its obligation by delivering the corresponding stock.

Taxation in Arbitrage Funds

Arbitrage funds are taxed like all other equity funds in India. Below is a breakdown of their taxation implications.

1. Short-Term Capital Gains (STCG) – if you sell arbitrage fund units within one year of buying, the gains are considered STCG and are taxed at a rate of 15% plus any applicable surcharge or cess.
2. Long-Term Capital Gains (LTCG) – if you hold your arbitrage fund units for more than one year before selling, the gains are considered LTCG. The taxation for LTCG is as follows: up to INR 1 lakh of LTCG earned in a financial year is exempt from tax. Gains exceeding INR 1 lakh are taxed at a concessional rate of 10% plus surcharge and cess.

Benefits of Arbitrage Funds 

1. Low Risk: These funds are widely considered to be among the less risky investments within the mutual fund category because they capitalize on price variations rather than relying solely on the general direction of the market.
2. Steady Returns: Arbitrage funds can generate consistent returns, even in highly volatile markets, by effectively capitalizing on short-term price inefficiencies. This can provide a buffer against market fluctuations and offer a relatively more consistent source of income.
3. Liquidity: These funds are highly liquid, so you can easily buy or sell your units on the exchange, allowing quick access to your invested capital.

Risks of Arbitrage Funds

1. Low Return: The arbitrage opportunities these funds explore usually involve minor price discrepancies. Despite their consistency, their overall returns may be lower than those of alternative, potentially riskier investments.
2. High Expense Ratio: The active management style and frequent trading involved in arbitrage funds strategies can lead to higher expense ratios compared to passively managed index funds. 

Performance Analysis 

Some popular funds’ returns are mentioned below:

Category Performance

Out of the 27 active schemes, 18 have outperformed the benchmark index. In particular, the SBI Arbitrage Fund has outperformed its peers, yielding 2.87% year-to-date.

The average returns of all schemes on the YTD basis are 2.33%, which is at par with the 2.34% returns by NIFTY 50 Arbitrage. For the year 2023, the average return was 7.34%, while the benchmark index registered a slightly higher figure of 8.11%.

Did you know?

The Nifty 50 Arbitrage Index aims to measure the performance of such arbitrage strategies. The index measures the performance of a portfolio involving investment in equity and equivalent short-position equity futures, short-term debt market investments and cash.

Conclusion

Arbitrage funds offer a unique proposition for investors seeking low-risk, steady returns and low taxes. Their capacity to leverage price disparities between markets possesses the potential to serve as a dependable revenue stream while functioning as a safeguard against market instability. However, they do come with limitations, such as lower overall returns than some investments. Therefore, the decision to opt for this fund should be taken after careful consideration. 

Remember that every investment carries some level of risk, and it is important to weigh the benefits against the risks involved. Always consult a financial advisor to align your choices with your financial objectives.

Frequently Asked Questions (FAQs)