Sudden rise of Arbitrage Funds – Should you invest?

Written by Vidya Kumar

September 2, 2014

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EXECUTIVE SUMMARY:  With the recent changes in the tax structure of debt funds suddenly Advisors, Agents and AMC’s have started talking about Arbitrage funds and how it can replace the debt funds in the short term. This has suddenly became the flavour of the season, however, before investing one should understand about product and should analyse and see if it fits to your risk profile and goal.   


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It was the period of April 2012 to May 2013 when RBI was in the phase of easing the interest rate. Looking at the opportunity Fund houses started pushing Debt funds and there was no sign of equity funds coming up. It was sold with a USP that NAV never comes down. Suddenly in July 2013 Debt fund shows negative return and becomes Villain in the market.

This time when Finance Minister announced the changes in the taxation related to the debt funds, suddenly AMC’s started discussing about Arbitrage funds. Few AMC’s started pushing it making it an alternative to the debt funds. So what are arbitrage Funds? How arbitrage funds work? Are these really an alternative of Debt funds? Let’s try to find the answer should you invest into it or not.

What are Arbitrage Funds?

People who are not familiar with the tem Arbitrage might think it as another equity fund. However, this is not true. The main aim of this fund is to seek an arbitrage opportunity between cash and derivative market and to generate an income.  Major part of the fund’s portfolio is invested into equities and rest is used for arbitrage opportunities.

How do these funds work?

There is always an arbitrage opportunity available in the stock market. What needed is the bull’s eye to catch the opportunity. Suppose ABC stock is trading in cash market at Rs.1000 and the same stock’s future price is 1010. Now, the fund manager can see the arbitrage opportunity and thus will sell the future contract in the derivative market and at the same time will buy the equivalent no. of shares in cash market. He will hold this position till the expiry. Now as it is definite that the cash price and future price will be same on expiry date, he will thus reverse the transactions. He will sell the shares in the cash market and will buy the future contract thus making the definite profit. Irrespective of the price, fund manager will make a profit out of this transaction.

It sounds very easy and simple but the problem lies in finding this kind of opportunities very frequently. Let’s understand it with an example.

ABC Stock

Cash market

Future market

Profit



Price on 10/08/14
Rs.1000/-
Rs.1010/-
N.A.
Scenario 1 – On expiry
Rs.1015/-
Rs.1015/-
Rs.10/-
Scenario 2 – On expiry
Rs.995/-
Rs.995/-
Rs.10/-

Scenario 1 –

ABC Stock was bought in cash market at a price of 1000 and in future market a lot was sold at a price of 1010. Now, on expiry day, the price of stock in cash and future market becomes same at Rs.1015. So a profit of Rs.15 was made by selling it in cash market and a loss of Rs.5 was booked by buying the future lot. In the end making a final profit of Rs.10/-

Scenario 2 –

ABC Stock was bought in cash market at a price of 1000 and in future market a lot was sold at a price of 1010. Now, on expiry day, the price of stock in cash and future market becomes same at Rs.995/- So a loss of Rs.5 was booked by selling it in cash market and a profit of Rs.15 was made by buying the future lot. In the end making a final profit of Rs.10/-

Why Suddenly Arbitrage funds are in focus?

With the recent changes in the tax structure of debt funds, the arbitrage funds have become the flavour of the season. Now gain on debt funds will be taxed at 15% if redeemed before 36 month and on the other hand if redeemed after 3 years then Long term capital gain will be taxed at 20% after indexation.

Arbitrage funds enjoy an edge over debt funds only because of Tax benefits. Arbitrage funds are taxed at 15% if redeemed before 1 year and no tax on gain over 1 year. The risk free return which is almost same as debt fund for 1 year makes it an attractive bet.

Is Arbitrage an alternative of debt fund?

Debt funds are an alternative to the fixed deposit and are used to earn fixed income over a period of time. There should be a specific time period behind putting money into debt funds otherwise the desired result will vary. The risk associated with debt funds is the interest rate risk.

Arbitrage funds are for those who can bear mild risk on their investment and want to invest only for Medium – short term.  These funds are managed so professionally that the probability of getting loss is very little. But still one cannot ignore the risk of volatility in the market. So, it is always advised to invest into arbitrage with a horizon of medium to short term with a minimum period of 1 year.

Should you invest?

People who are looking for wealth creation should stay away from arbitrage funds as they will not generate good returns over long period. Instead a plain equity fund should be the way to create wealth.

If you are looking for an alternative of debt fund for less than 2 – 3 years and if you can’t bear any kind of risk then FD should your choice not arbitrage funds. If the goal is of 1-2 years then only arbitrage funds can be given a priority over debt funds.

These funds are to provide short term tax free gains, so their weightage should be around 10% in your portfolio and should not be used for wealth creation in long term. So before investing think about your goal, time period and then invest. Just by riding in the wave of flavour of the season will not help you in reaching your goal.


This article was originally published on Indianotes. The author can be reached at [email protected]

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