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Arbitrage Funds: Why It’s A Good Investment Bet During Volatility

Adhil Shetty

Equity arbitrage funds are one of the best ways to reap the benefits of a volatile market without taking on too much risk. Here is a quick guide to arbitrage funds.

Arbitrage Funds: Why It's A Good Investment Bet During Volatility

When looking at short-term options to invest your liquid cash, there are very few options, which offer attractive returns and at the same time are risk-averse. As such, debt funds, Fixed Deposits and storing money in savings accounts were counted as the best options. However, with changes in the tax and banking regimes, fixed deposit rates have been lowered while the interest earned from them remain taxable.

Interest rates offered by Savings Account are conservative while debt funds can be used as a foundation to build your portfolio but not to boost your profits. Equity Arbitrage funds are one of the best ways to reap the benefits of a volatile market without taking on too much risk.

What Are Arbitrage Funds?

Arbitrage fund is a type of a Mutual Fund that exploits opportunities in the stock market arising due to market volatility. Fund managers use the fund to invest the money in arbitrage opportunities and earn a profit from the difference in spot price and future price of a stock.

How Do Arbitrage Funds Work?

Basically, arbitrage funds invest money by purchasing the stock of a particular company in the spot (cash) and then look to sell that in the derivatives market. For example, the current share price of Company A is Rs. 100. But the future contract for the same share after 30 days is valued at Rs. 110 per unit. In such case, the investor will purchase, let’s say 100 units in the spot, investing about Rs. 10,000 and sell that in the futures market. At the end of the 30 days, when the future price and spot price coincides, the stock will be worth Rs. 11,000 (at Rs. 110 per unit for 100 units) and the investor will make a profit of about Rs. 1,000 before miscellaneous expenses.

Now, this was a rather simplistic example of how an arbitrage investment usually works. But as seen from the illustration above, the working of arbitrage fund hinges on the fluctuations in the market. After the sale of the future concludes, expenses like security transaction tax, service tax, and brokerage fees trim the resulting profit.

Advantages Of Arbitrage Funds

As seen above, arbitrage mutual funds offer great versatility in volatile market conditions since that’s when prices fluctuate most. But other than offering increasing profit-making opportunities, arbitrage funds also offer tax savings features.

If you’re investing for 12 months or less, returns from the mutual funds are taxed at 15%, while if you’re investing for a horizon greater than 12 months (i.e. long-term gains) the returns on Arbitrage funds in excess of Rs. 1 lakh will be subject to 10% LTCG tax. In comparison, fixed deposits and savings account interests are all taxed at the same rate as the income tax rate applicable to the investor. So, for example, if your annual taxable income falls in the higher-end bracket of the tax slab, you’ll be taxed at 30% and the returns from the fixed deposits and savings accounts will also be taxable at 30%.

The returns from your arbitrage funds will be taxed at 15% for less than one year.  If you want your mutual funds to pay-out dividends instead of just handing out the return, then your dividend will be taxed at 10%

While you can start out arbitrage investment on your own, it can be a bit risky, since most people lack the experience in realising and executing such opportunities. Alternatively, investing in an arbitrage mutual fund offers the increased safety of having your money spread out across multiple arbitrage opportunities and realising a profit from there on.

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