Arbitrage funds have seen some revival in investor interest in recent times. Most often these funds have been pitched to investors as an alternative to debt funds for parking short-term surpluses, given their tax advantage. But that is why you invest in Liquid or Sort term debt fund. So, are the seemingly risk-free arbitrage funds a better alternative to shorter-duration debt funds?

Let’s understand what arbitrage funds are, how they work, and why they can be pitched against liquid funds & their tax benefit.

Understanding Arbitrage Funds

An arbitrage fund is a type of fund which puts money in the cash and derivatives market in order to generate returns.

The Fund aims to generate returns by engaging in arbitrage opportunities and taking advantage of the spread or the differential in the price of a stock in the spot market (that is the stock market) versus its price in the futures market.

Most stocks generally trade at a premium in the futures market (unless the market sentiment turns very bearish) and this provides the spread.

Here is an example

Suppose a fund buys the stock of company ABC at Rs.200 & also sells the ABC stock futures at Rs.201
The fund can continue to hold its position till the expiry of the futures contract. Alternatively, it can close the contract or roll it over to say the next month, before the expiry date.

On expiry, both future & spot costs will converge. So, the following outcomes will happen assuming nil transaction cost:

Another example:

Points to Note

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The volatility of the asset decides the return level in it.

These funds capitalize on market inefficiencies and generate profits.

They function by determining the difference in price which should generally have the same price.

The price differential is generally small. So funds make large trades in order to generate higher returns.

Few of these funds make small profits by buying and selling stock on different exchanges with a minimal difference in price. For eg, Rs 10.05 on the Bombay Stock Exchange and Rs 10.10 on National Stock Exchange.

Benefits of Arbitrage Fund

The main benefit of investing in arbitrage funds is that they are less risky since the stock is bought and sold simultaneously.

If there are fewer opportunities in trades, they will allocate a proportion of their investment into debt securities. These are also relatively more stable. So it makes a good investment option for low risk-taking capable investors.

Another attractive benefit is that they are taxed as equity funds. So for an investment of less than a year, you need to pay 10% (after Rs 100000 of gain). Similar investments in say liquid funds (if redeemed before 3 years) will be taxed at marginal tax rate (as per your slab of income). Now, this is particularly good for large-scale investors like HNIs & Corporates. (MF taxation – Click Here)

Risk in Arbitrage Funds

Although the funds trade in stocks but they are considered to be a low risk since they don’t hold the stock (stocks are bought and sold simultaneously). This makes these funds nearly as safe as debt funds.

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The trades in arbitrage funds are a short windows of opportunity that can be exploited by taking action at the right time. So expecting long tenures of the same returns is not there.

These fundshave higher expense ratios which makes it less attractive to investors as it shouldn’t be a big part of your investment portfolio.

Arbitrage funds engage in simultaneous buy-sell activities and, thus, they can have higher transaction costs attached to them, which may affect returns.

These have made negative returns in time when markets is facing low volumes & low volatility.

If the horizon is medium to long term, actively managed equity funds tend to outperform arbitrage funds.

If there is no volatility, arbitrage funds would work as a bond fund. These will be impacted by interest rate movements.
While comparing arbitrage funds over liquid funds, it was found that

These funds can generate negative returns as they are more risker than liquid funds over a short-term period. Hence money kept in liquid funds for a shorter period of time is more safe and liquid.
They have a lower probability of beating liquid funds. As in the past, arbitrage fund’s pre-tax returns is not greater than liquid fund’s average return majorly. This may again happen when interest rates rise in the future.
Arbitrage fund returns are good until the tax advantage of the equity fund is there.

When you should invest in Arbitrage Funds?

If you are investing for the short term in volatile markets.
You are looking for more post-tax return investments and the time horizon is medium.
Temporary parking the funds.

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Looking forward to your questions through email or comments section below.