Arbitrage funds are recently creating its own space among the investors who are risk avert and desire to earn moderate income out of it. The depleted interest income on bank deposits is continually pushing investors towards mutual funds. In fact, mutual funds in the form of liquid funds, ultra short term debt funds and arbitrage funds have proven worthy alternatives to the bank deposits. So far as Arbitrage Funds are concerned, they are unique as they take benefit out of market volatility and generate stable and risk-free returns. Let’s explore the things deeper.
What Is An Arbitrage Fund?
Arbitrage Fund is an equity oriented hybrid mutual fund. Arbitrage fund works by exploiting the price difference between the stock cash segment and future derivatives market. The mechanism is a bit complex. We will understand them in the later part of this article.
In Arbitrage funds, more than 65% of the investment portfolio comprises of equity, hence it is treated as equity-oriented funds. But the interesting fact is they deliver risk-free returns to their investors. This way it gives the best of both the worlds- favourable tax benefits of equity funds and risk-free returns of debt funds.
How Does An Arbitrage Fund Work?
If you want to invest in arbitrage funds, this is crucial. Because without understanding its complete investment mechanism you will be nowhere to understand the benefits of it. Arbitrage funds are unique from other funds in terms of the investment process and profit generation. Rather than buying stocks and then selling them at a higher price to gain profit, Arbitrage Funds work differently. In Arbitrage funds, the fund manager buys some stock of a company in the cash segment and simultaneously sells futures of the same company in the derivatives market, if futures are trading at a reasonable premium.
Let’s understand the matter with an example:
Fund A buys 100 XYZ Stocks at the start of August for Rs. 500 each (cash segment) and sells XYZ August Futures at Rs. 520 each (derivatives market). Now on the expiry of the Futures, either of the two situations will arise. The stock price in cash segment may go up or go down.
Case I: Stock price goes up
Stock price at expiry: Rs. 530
Cash segment: Gain of Rs. 30 (530-500)
Futures Derivative: Loss of Rs. 10 (520-530)
Net gain: Rs. 20 (30-10)
Case II: Stock price goes down
Stock price at expiry: Rs. 490
Cash segment: Loss of Rs. 10 (490-500)
Futures Derivative: Gain of Rs. 30 (520-490)
Net gain: Rs. 20 (30-10)
In the above cases, it is seen that in both the market conditions Fund A has gained out of stock price fluctuations. This happens because Fund A has entered into two reciprocal transactions of exactly the same quantity. In an arbitrage fund, each transaction exposure is covered up by another transaction which exactly of the opposite nature. So, there can be hardly any loss.
At the same time, you need to know about future derivatives and their nature of the operation. A future contract is a contract between the parties where both the parties agree to buy and sell a particular asset of a specific quantity at a predetermined price, at a specified date in the future. As futures contracts are standardised in terms of expiry dates and contract sizes, they can be freely traded on exchanges. They normally expire in the last week of the month. So naturally, the roll-over of arbitrage position happens on the expiry i.e. in the last week of the month and this period is considered ideal for withdrawing from arbitrage funds.
When Should You Go For Arbitrage Funds?
This part of the blog covers two things- A) the timing and circumstances of the market and B) the economic position and requirement of the investor, favourable for investing in Arbitrage funds.
A)The Timing and circumstances of the market
As we have read earlier that arbitrage funds are dependent on future contracts which have some standardised expiry date, normally last Thursday of the expiry month (in India). On that day all the transactions are settled. In the case of Arbitrage Fund, the spread i.e. difference between the cash and future positions keep on fluctuating from starting of futures position to expiry. At the end of the month when a futures contract expires, the cash price and future price of the stock converges, the spread is minimum. So, it would be profitable from an investor’s point of view, when the spread is maximum.
Arbitrage fund investments are also appreciable when the market is highly volatile and at the same time, investors want a moderate income without losing wealth. Because in stable market conditions, the difference in price between the cash segment and the future market of the stock, is less. Hence arbitrage opportunities are also less and so as their gains.
B) The economic position and requirement of the investor
This is vital as there are alternative options rather than investing in arbitrage funds. There are Liquid funds and Ultra Short Term Debt (USTD) funds that give the same or you can say better returns compared to arbitrage funds. Then why should we go for arbitrage funds? Well, there is a twist in it. Both the Liquid and USTD funds come under debt-oriented funds and for income tax purpose they’ll be treated as short term capital asset if held for less than 36 months and any gain on that will be treated as short term capital gain, which is taxable. But, arbitrage funds are treated as equity-oriented funds, for which the time period is 12 months for treating it short term capital asset. So, we can say arbitrage funds are more tax favourable funds comparing to the other funds.
Next, the financial position and tax bracket of the investors too equally important in deciding whether to invest in arbitrage funds or not. An analysis shows that if you are in the lowest or no tax bracket then, the post tax return from arbitrage funds in short term period is lower than Liquid or USTD funds. On the other hand, if you come under the highest tax slab it is advisable to go for arbitrage funds. So, the argument for investing in Arbitrage funds varies from case to case.
Then another important factor that needs attention is exit load. It’s worth mentioning that, there is no exit load in Liquid funds or USTD funds. But in the case of arbitrage funds fund houses charge exit load if they are withdrawn before a specified period ranging from one month to six months. So, if your investment tenure ranges from above six months to less than 3 years, arbitrage funds are treated as good investment opportunities. Before investing in an arbitrage fund read the terms and conditions carefully, especially the exit load clause.
It is to be noted that though arbitrage funds are equity-oriented funds, they are not meant for long term wealth creation. These are basically used for parking funds rather than blocking it in saving accounts where the return is just 4 percent or less than 4 percent. Before investing in arbitrage funds you should consider your requirements and assess your taxability. At the same time reaffirm with the fund houses that no way their arbitrage fund’s equity holdings comes below 65 percent. Because on that occasion, it will be treated as debt-oriented funds and the tax benefits mentioned above may be lost.