Arbitrage funds are equity-oriented hybrid mutual funds. They take advantage of price differences in different securities' markets. An arbitrage fund manager will purchase and sell securities in different markets simultaneously and generate returns through differences in the cost price and selling price.
A major portion of the portfolio of an arbitrage fund is allocated to equity. The rest is allocated to debt, money market instruments and cash.
There are different ways in which arbitrage works -
1) The shares of a company – XYZ Ltd. is trading at ₹805 in the stock market. The value of a one-month futures contract is ₹825. The fund manager will buy the stock at ₹805 and enter into a contract to sell one-month futures at ₹825. At the end of the month, he will make a profit of ₹25 less transaction fees.
2) The shares of a company – XYZ Ltd. Is trading at ₹805 in the stock market. The fund manager has analysed and concluded that it will lose value three months down the line. The three-month futures contract is priced at ₹792. The fund manager short sells the stock at ₹805 in the stock market and agrees to buy the three month futures contract at ₹792. He makes a profit of ₹13 per share less transaction charges.
How Are Arbitrage Funds Taxed?
From a tax perspective, arbitrage funds are treated like equity funds. If you stay invested for a period less than one year, your sales proceeds are considered as short-term capital gains (STCG), which are taxable at 15%. If you sell your investments after a year or more, the gains will be treated as long-term capital gains (LTCG). If the amount of LTCG in greater than ₹ 1,00,000, it will be taxed at the rate of 10% without the benefit of indexation.
How Have Arbitrage Funds Performed?
Here are the returns of some arbitrage funds along with their CRISIL rating. Please note that this is historical performance and does not indicate future performance.
Arbitrage funds take advantage of price differentials. Therefore the returns will be moderate and not very high like equity funds. Risk is low as the fund manager takes buy and sell positions. Moreover a portion of the portfolio is allocated to debt and money-market instruments, reducing investment risk further. Arbitrage funds are good for conservative investors.
The tax treatment is similar to equity funds. For fixed deposits, you will have to pay tax as per your income tax slab if the interest income exceeds Rs. 10,000 per year. In case of debt funds, gains earned will be added to your income and your tax liability will be as per the income tax slab applicable in case you held the debt funds for a duration of up to three years. If you held them for longer than three years, a tax of 20% will be applicable. From a tax perspective, arbitrage funds are favourable.
Consider your time horizon. If you require your investment money in a short-term of 3-6 months, arbitrage funds are not the best bet. You may be better of investing in a liquid fund. If your money can remain invested for a longer time, arbitrage funds are better.
There is higher churn in arbitrage funds. The managers will be buying and selling more in these funds as compared to liquid funds or large cap equity funds. Therefore the expense ratio will be high.
Arbitrage funds fare better than cash, fixed deposits and liquid funds in the long run. Usually equity funds usually give better returns than arbitrage funds. Moreover redemption from arbitrage funds takes time compared to other mutual funds.
A part of your investment portfolio can be allocated to arbitrage funds for a long term perspective.