Bank Fixed Deposits are amongst the most popular investment options for many. But with the interest rate on bank FDs falling, they no longer appear to be as lucrative. Also, the interest rate earned on bank deposits are taxable. Many investors thus explore other avenues that can give better returns. Arbitrage Fund is one such option.
Understanding Arbitrage Funds
Arbitrage funds are Mutual Funds that make use of the cash and future prices of stocks or arbitrage the difference to their advantage. The fund manager of an arbitrage fund will buy shares in the cash market and sell the same in the futures or derivative market. The difference in the price is the effective return on offer for the investors.
For example, the share price of a stock ABC is trading at Rs 1,000 in the cash market and Rs 1,025 in the futures market. An arbitrage fund manger would buy same number of shares from the cash market and sell in the futures market on the settlement date (which is the last Thursday of the month).
So let’s assume ot the day of settlement, the stock price moves to Rs 1100. The fund gains Rs. 100 in the cash market (1100-1000) and loose Rs. 75 (1025-1100) making an overall gain of Rs. 25.
Let us also assume on the day of settlement, the stock price moves to 900. The fund looses Rs. 100 in the cash market (900-1000) and gains Rs. 125 (1025-900) making an overall gain of Rs. 25.
Eventually the arbitrage fund gains irrespective of the movement of the stock price if the fund manager plays it smartly. Thus, the functioning of an arbitrage fund usually hinges on the market fluctuations. Costs like security transaction tax, service tax, and brokerage fees reduce the resulting profit after the sale of the future ends.
Arbitrage Funds Vs Fixed Deposits
The average exposure of arbitrage funds is more than 65% in the equity, so they get the same tax treatment as equity funds. Therefore, short term gains or STCG are taxed at the rate of 15% while long term LTCG exceeding Rs.1 Lakhs are taxed at 10% without the benefit of indexation. Whereas, the interest earned on bank fixed deposits are taxable at the same rate as the income tax rate applicable to the investor. So, you will be taxed at 30 per cent if your annual taxable income falls in the higher-end bracket and the returns from the fixed deposits will also be taxed at 30%.
The arbitrage opportunities also come down with more people investing in arbitrage funds instead of the regular cash or derivatives market. Timing the buy-sell calls remain paramount and sometimes even an experienced fund manager can get it wrong.
The average rate of return for arbitrage funds ranges between 6%-7% over a period of 5-10 years. Bank Fixed Deposits on the other hand come with an assured return and fetch somewhere between 4-9%.
Arbitrage funds come with an annual fee or expense ratio charged as a percentage of the fund’s assets. In addition arbitrage funds come with an exit load. So unless you are looking at a long term investment an arbitrage fund may not be the most pocket friendly investment tool.
An arbitrage fund being an equity oriented fund can be a risky proposition for an average investor due to lack of knowledge and experience. But it also offers the safety of your money being spread out across multiple arbitrage opportunities, and realising a profit from there on.
(The writer is CEO, BankBazaar.com)