Arbitrage funds are favored by many mutual fund investors, especially high net worth investors. They use it as a strategy to park money for a short period because of their edge over debt mutual funds in terms of taxation.It is also preferred by those investors who do not like to take a risk and invest in short term debt mutual fund or bank fixed deposit which have the benefit of predictable return. If you fall into a high tax bracket, arbitrage mutual fund schemes are expected to offer marginally higher post-tax returns than debt mutual funds. However, this will not be the case always.
Arbitrage mutual fund is the simultaneous buying and selling of an asset in different markets to benefit from the price difference. A stock gets traded on the various market like BSE, NSE which are the Cash market and also derivates market which deals with the future cost of a stock. To understand it more clearly let’s say a stock “Z” which trading at Rs 100 on the BSE and at the same time, it is trading at Rs 102 on the derivates market. So, an arbitrage fund manager buys ‘n’ number of stock Z on the BSE and sells the equal number of stocks on the derivates market to benefit from the price difference. Arbitrage funds create positions in the equity spot and futures markets to exploit arbitrage opportunities that arise due to mispricing in these markets. The movement in price can be due to news related to the stock, it’s quarterly and annual results, etc. Investors should be aware of the risk as well. Extreme conditions in equity markets can cause temporary disruptions.
Arbitrage funds have delivered an average return of 5.68% over the past year and 5.75% over the past three years, according to data from Value Research. This is quite similar to 5.66% and 6.48% in liquid funds. In the case of arbitrage, you are not investing in the fundamentals of equity, you are trying to exploit the price difference of an asset on the various market. Therefore, there is no risk of equity and because of risk-free nature, arbitrage funds usually compared with Liquid funds. These funds give returns like liquid funds.
A volatile market gives a lot of arbitrage opportunities. Hence, arbitrage performs best in a volatile market. Arbitrage funds are treated as equity funds from a taxation perspective and give return like the liquid fund, which makes them attractive among short term investors. If you sell your arbitrage fund within a year, you make short term capital gains which are taxed at 15% irrespective of your tax slab. If you include surcharge and cess, the tax would be 17.3%. If you sell funds after a year, you make long term capital gains and there are no taxes. In the short-term, if you are in the tax bracket of 20% or 30%, making decisions in favor of the arbitrage fund would be more profitable as these funds are taxed at 15% whereas liquid funds are taxed according to your tax slab. In case you are in the bracket of 10%, go for the liquid fund. Tax treatment of debt fund which was changed a few years back has made arbitrage fund a preferred short-term investment revenue. Arbitrage funds will be suitable for parking your short-term fund.
