Arbitrage Fund

Arbitrage Funds: 

The Secret to Low-Risk, Tax-Efficient Returns?

In the world of investing, the pursuit of high returns often comes with high risk. But what if there was a way to capture market inefficiencies for profit, without being exposed to the wild swings of the stock market?

Enter the Arbitrage Fund, a unique type of mutual fund that operates on a clever and surprisingly simple principle. For investors looking for a safe haven for their cash with the added perk of tax efficiency, arbitrage funds might just be the perfect fit.

What exactly is an Arbitrage Fund?

An Arbitrage Fund is a type of hybrid mutual fund that aims to generate returns by exploiting price differences of the same asset in different markets. In simpler terms, these funds buy a stock at a low price in one market and simultaneously sell it at a higher price in another market, locking in a small, risk-free profit.

The most common strategy involves the price difference between the cash market (where you buy stocks for immediate delivery) and the futures market (where you agree on a price for a future date).

How does it work? A small example

Let's say shares of "ABC Corp." are trading at Rs. 1,000 in the cash market. At the same time, the one-month futures contract for ABC Corp. is trading at Rs. 1,010.

An arbitrage fund manager would:

1. Buy the shares for Rs. 1,000 in the cash market.
2. Simultaneously sell the shares for Rs. 1,010 in the futures market.

By doing this, the fund has locked in a guaranteed profit of Rs. 10 per share, regardless of what the stock price does in the future. The fund isn't betting on the stock going up or down; it's simply profiting from the existing price difference.

Advantages of Arbitrage Funds

1. Low Risk Profile

Because arbitrage funds are not dependent on the market's direction, they are considered one of the safest categories of mutual funds. They are designed to generate returns from market inefficiencies, not market movements, making them relatively insulated from volatility.

2. Tax Efficiency (Arbitrage Fund Taxation)

This is where arbitrage funds truly shine. Even though they have a risk profile similar to a debt fund, they are taxed like equity funds in India.

• Holding Period: You only need to hold them for 12 months to qualify for long-term capital gains (LTCG).
• LTCG Tax: The long-term capital gains are taxed at just 12.5% (on gains above Rs. 1.25 lakh per year).
• STCG Tax: Short-term gains (if held for less than a year) are taxed at 20%, which is still lower than the slab rate for many investors.

This tax treatment makes them a highly attractive alternative to traditional fixed deposits or liquid funds, especially for those in higher tax brackets, i.e. 20% and above.

3. Higher Return Potential than Liquid Funds

While not as high as pure equity funds, arbitrage funds typically offer in that range of 6-7%, better returns than liquid funds or ultra-short-term debt funds, especially when arbitrage opportunities are plentiful.

What are the Downsides or Risks to consider?

1. Limited Return Potential: The trade-off for low risk is limited returns. In stable markets with few price differences, arbitrage funds may struggle to find profitable opportunities and could underperform.
2. Expense Ratio: These funds are actively managed and involve frequent trading, which can lead to higher transaction costs and expense ratios.
3. Credit Risk: To generate returns when arbitrage opportunities are scarce, these funds invest a portion of their portfolio (up to 35%) in debt instruments. If the fund invests in low-quality bonds that default, it can negatively impact the NAV.

Exit Load of Arbitrage Fund?

Arbitrage fund exit loads vary by fund but typically are a small percentage, ranges from 0.25% to 0.50%. if units are redeemed or switched out within a short period, often 7 to 15 days from the allotment date. After this initial holding period, there is generally no exit load charged for redeeming or switching out units. It is essential to check the specific terms of the arbitrage fund you are investing in, as the holding period and exit load percentages can differ between funds and asset management companies (AMCs)

Who should Invest in Arbitrage Funds?

Arbitrage funds are an excellent choice for:

• Risk-Averse Investors: If you're looking for a safe place to park your money for a short period (6-12 months) and want better post-tax returns than a fixed deposit, this is a great option.
• Investors in Higher Tax Brackets: The equity taxation makes these funds highly efficient for those in the 20% or 30% tax slabs.
• A Temporary Parking Spot: If you have a lump sum of money that you plan to invest in equities later (perhaps through a Systematic Transfer Plan), an arbitrage fund can be a great place to hold it while generating modest, tax-efficient returns.
• Emergency Fund : It is better to park in an Arbitrage Fund and any emergencies (3-12 months expenses). Especially those with higher income tax slabs (>20%). 

By understanding how arbitrage funds work, you can leverage them as a smart, low-risk tool in your investment portfolio, balancing safety with tax-efficient growth.

Regards,

Honvest Team.