What are Arbitrage Mutual Funds?

Imagine you discover that a particular brand of vintage sneakers is in high demand. You find them at a local store near you for ₹2,000. But the same make and model is being sold online for ₹5,000 on a popular resale site. If you buy from the local store and sell online you can make a smart profit of ₹3000. 

Arbitrage funds adopt a similar approach. They try to take advantage of the price differential in the stock market to make returns. Let’s understand in detail what arbitrage mutual funds are, how they work and the benefits and risks of investing in these funds.

What is Arbitrage Fund?

An arbitrage fund is a hybrid mutual fund that aims to generate profit from the difference in prices of securities in the derivatives and cash market. In simple terms, a fund manager might purchase stock in the cash market and simultaneously sell it at a higher price in the futures market, thereby earning a profit from the price difference between cash and futures markets.

These funds have at least 65% of assets in equity and equity-related instruments. The remaining assets are invested in low-risk options like short-term bonds or term deposits.

Unlike traditional fund managers who spend time analysing companies, purchasing fundamentally sound stocks and waiting for them to grow, arbitrage fund managers focus on finding price differentials in the spot and futures market to make their trades.

Arbitrage funds are a great option for low-risk investors looking to earn good returns, especially when the market is volatile. They are taxed like equity funds because equity represents at least 65% of the investment portfolio.

Key Characteristics of Arbitrage Funds

Here are the features of arbitrage funds:

Low-Risk Funds: An arbitrage fund is a low-risk investment option as it minimises risk by adopting hedging techniques. 

Suitable During Unstable Markets: Volatility is the friend of arbitrage mutual funds. They are suitable for investors with a low-risk appetite who want to profit from volatility without taking on too much risk.

Equity-Oriented Funds: They are treated as equity funds for taxation purposes, as they hold 65% of assets in equities and related instruments. 

How Do Arbitrage Funds Work?

Before moving to how arbitrage funds work, let’s understand the meaning of arbitrage. Arbitrage is when you buy and sell the same asset simultaneously in different markets to earn a risk-free profit from price inefficiencies between the markets. 

An arbitrage fund uses this principle. It buys a stock in the cash market where the price is lower and sells it in the futures market where the price is higher. By doing this, the fund ensures a profit from the difference between the two prices. 

On the last day before the futures contract expires, the prices in both markets usually match up. This is when arbitrage funds complete their strategy. They do this by selling the stock they bought earlier in the cash market and buying back the same stock from the futures market.

Let's consider a scenario where the share price of XYZ stock at the time of purchase in the cash market is ₹150, and it is simultaneously sold in the futures market for ₹160. Here are the three scenarios of the stock on F&O expiry:

Initial Values:

Purchase price in the spot market: ₹150

Selling price in the futures market: ₹160

Price on F&O Expiry:

Price at Expiry: ₹170

Buy at ₹150 in the spot market: Profit of ₹20 (₹170 - ₹150)

Sell at ₹160 in the futures market: Loss of ₹10 (₹160 - ₹170)

Profit: ₹10 

Price at Expiry: ₹140

Buy at ₹150 in the spot market: Loss of ₹10 (₹140 - ₹150)

Sell at ₹160 in the futures market: Gain of ₹20 (₹160 - ₹140)

Profit: ₹10 

Price at Expiry: ₹150

Buy at ₹150 in the spot market: No gain/loss (₹150 - ₹150)

Sell at ₹160 in the futures market: Gain of ₹10 (₹160 - ₹150)

Profit: ₹10

In each scenario, the profit is calculated based on the difference between the spot market purchase price and the futures market selling price.

Benefits of Investing in Arbitrage Mutual Funds

The following are the benefits of investing in arbitrage funds:

Lower Risk: An arbitrage fund carries moderately low risk. Since the buying and selling of securities is happening simultaneously, arbitrage funds hedge their bets and there is virtually no risk associated with long-term investments. Further, these funds have exposure to relatively stable debt instruments. 

Scope of Steady Returns: By capitalising on price differentials in the market, arbitrage funds generate steady returns. They tend to make good returns especially when the markets are volatile. They can be lucrative investments for those seeking a reliable income stream. 

Taxation Benefit: Arbitrage funds have 65% of their assets in equity and related schemes. Therefore, they are taxed like equity funds despite holding debt securities. Short-term gains from these funds are taxed at 20% and long-term gains at 12.5% after an exemption of ₹1.25 lakh. This makes them more tax efficient than debt funds, which are taxed at the individual’s income tax slab rate. 

Risks of Investing in Arbitrage Fund

Here are the possible risks involved with arbitrage funds:

High Expense Ratio: Since an arbitrage fund requires active management to spot arbitrage opportunities, they have a higher expense ratio.

Interest Rate Risk: Arbitrage funds invest a portion of their assets in debt funds and are open to interest rate fluctuations. Any sharp change in interest rates can impact the net asset value (NAV) of the fund. However, this risk is minimal as arbitrage funds generally hold short-duration debt instruments.

Smaller Returns: Arbitrage funds typically have limited profit potential because the price differential that the arbitrage funds aim to exploit is generally small. They tend to give lower returns than other equity funds.

Who Should Invest in Arbitrage Funds?

An arbitrage fund is suitable for the following kinds of investors:

• Investors who are keen on tax efficiency can consider investing in arbitrage funds since they enjoy the taxation benefits of an equity fund.
• Investors who want to profit from a volatile market without taking on too much risk.

Tax Implications of Arbitrage Funds

For taxation purposes, arbitrage funds are treated like equity mutual funds. Therefore, any gains made from an arbitrage fund are subject to capital gains tax as follows:

Short-term capital gains (STCG)

If you sell your mutual fund units within 12 months, then any gains made on investment are known as short-term capital gains. They are taxed at a flat rate of 20%.

Long-term capital gains (LTCG)

If you redeem your mutual fund units after 12 months, then gains made on investment are known as long-term capital gains. Returns up to ₹1.25 lakh are exempt from tax and above that you have to pay tax at 12.5%.

How To Invest in Arbitrage Funds 

You can invest in the best arbitrage funds using the INDmoney app in a few easy steps:

• Open the INDmoney app and log in with your credentials.
• Navigate to the "Mutual Funds" section within the app.
• Use the filter option to select "Arbitrage Funds" to view the available choices.
• Choose between a lump sum investment or a Systematic Investment Plan (SIP) for regular investments.
• Enter the amount you wish to invest and confirm the transaction.