Arbitrage Funds, as the name suggests, funds which make money from Arbitrage opportunities.
Many investors are not familiar with this type of Mutual Funds. They normally know Equity Funds, Debt Funds etc and think Arbitrage Funds are just other fancy schemes under Equity Funds.
However this is not the case.
Arbitrage Funds Definition / Meaning
“Arbitrage” means – The simultaneous buying and selling of securities, currency, or commodities in different markets or in derivative forms in order to take advantage of differing prices for the same asset.
Actually Arbitrage Funds are niche category of mutual funds that aim to take advantage of arbitrage opportunities between spot (cash) and future markets. The arbitrage is sought by taking advantage of the mispricing between the cash and the derivatives market. So they trade in Equity & Equity derivatives but generate income similar to Fixed Income.
Let’s understand through an example
- On 03/07/2014 – Reliance Industries (RIL) spot price – Rs 1004.90 & RIL Futures 25/9/2014 – Rs 1028.80 (market lot 250)
- On 03/07/2014 – Buy 250 Shares of RIL in Spot market @ 1004.90 = Rs 251225
- On 03/07/2014 – Sell 1 lot (250) of RIL in Future market for Rs 1028.80 with expiry date 25/09/2014
- On 25/09/2014 – Sell 250 Shares of RIL in Spot market at Market price.
- On 25/09/2014 – You will get 250 * 1028.80 = Rs 257200 irrespective of Market Price
So your total earnings will be Rs 5975 over a period of 84 days (4-Jul to 25-Sep)
This is equivalent to 10.3% p.a.
This return is risk free as both contract (buy & sell) happens at the same time (03/07/2014).
|03/07/2014||Buy RIL – 250 shares @ 1004.90||251225|
|03/07/2014||Sell 1 lot of RIL Future @ 1028.8
|25-Sep-14||if RIL Price in Market is Rs 1100||275000||275000|
|Profit / Loss||23775||17800||5975|
|25-Sep-14||if RIL Price in Market is Rs 900||225000||225000|
|Profit / Loss||-26225||-32200||5975|
Irrespective of market price on 25/09/2014, the profit will be Rs 5975.
How do they make money?
The ability of these funds to generate higher returns depends on the volatility in equity markets – the higher the better. Fund Managers use sophisticated software’s that flag any mispricing the moment it occurs.
Arbitrage funds taxation aspects
Taxation is one of the USP for Arbitrage funds. While it is a substitute for debt products on a risk-return basis, arbitrage funds are taxed as equity.
So, the long-term returns will be tax-free. The short-term capital gains are taxed at a special rate of 15%, plus surcharge.
The dividend option of arbitrage funds is further lucrative as dividends are tax-free for equity funds, while short-maturity debt funds are subject to dividend distribution tax. However, these should have an equity holding of over 65% to be classified as equity funds.
Arbitrage funds can act as an alternative to short-term debt funds as they have generated higher returns in the short-term.
Returns of Arbitrage Funds (Best performing Arbitrage Funds)
|Arbitrage Funds||AUM||1 Yr||2 Yr||3 Yr||5 Yr|
|ICICI Pru Blended Plan – B (G||303||10.9||10.1||10.2||9.2|
|ICICI Pru Eqty-Arbitrage-Direct (G)||1285||7.1||7.8||8.5|
|HDFC Arbitrage Fund – WP – DP (G)||128||7||7.5|
|JM Arbitrage Advantage -Direct (G)||1733||7||7.6||8.3|
|Kotak Equity Arbitrage – Direct (G)||962||6.9||7.8||8.7|
|As on 15-Sep-2016||Complied by Wealth18.com|
Note that the returns for the same DIRECT PLANS are approx more by 0.5%
Read My other post on – Top Performing Arbitrage Funds
Arbitrage Funds Vs Debt Funds
- 1) The main difference between Arbitrage funds & debt funds are Taxation aspects as discussed above.
- 2) Debts funds invest in Fixed Income Securities and have interest rate risk while Arbitrage funds are almost risk free.
Point to Note
- 1) Arbitrage & Arbitrage Plus – Investors need to differentiate between pure arbitrage and arbitrage plus funds. In the former, the equity component is completely hedged while the latter can take unhedged positions and carry a higher risk.
- 2) These funds should have an equity holding of over 65% to be classified as equity funds.
- 3) Returns are similar to Interest rates prevailing in the market but are more tax efficient.
Arbitrage funds are good option for Investors in higher tax bracket as they generate risk free income and are tax efficient.
Have you heard about these funds before reading this article? Have you invested in Arbitrage funds before? What are your views on such funds? Do you have any query related to such Arbitrage funds?