Arbitrage Mutual Funds: Advantages & Disadvantages | Detailed

Arbitrage Mutual Funds: Advantages & Disadvantages | Detailed

Arbitrage funds are a result of market imperfections. Almost riskless in their performance, arbitrage mutual funds are considered as a safe harbor. Investors with lesser risk appetite are known to investment in this fund category. Let’s know more about this fund in this interesting read.

What is the Concept of Arbitrage?

Arbitrage is the price differential between two different markets for the same product.  Arbitrage funds benefit from the price difference of current and future securities in different markets to earn maximum returns. This works by incorrectly pricing the equity shares in the spot and futures market. Arbitrage funds are bought in the cash market and sold in futures markets to earn returns.

What is an Arbitrage Mutual Fund?

An arbitrage fund is a type of mutual funds which takes the advantage of the market volatility to make profits without taking too much risk. In a typical market a fund or an investor purchases stock or equities to sell when the stock prices go up or in simple words in a bullish market. The price at which the stock is bought in the cash market (stock trading market) is the spot price. In futures, stock is valued at an anticipated price of the future. It is referred to as a derivative market where a financial security is dependent on an underlying asset and derives its value from the fluctuations in assets.

For example, Spot price of a stock of XYZ company is Rs 50 which is expected to rise to Rs 70 in a bull market, in the above case an investor can go for an arbitrage fund and buy stock in the cash market and sell a contract in the futures market. In an opposite scenario i.e., when the market is bearish, arbitrage funds can buy lower priced stock in the futures market and sell in the cash market at a higher price.  

Should you invest in Arbitrage Funds?

Arbitrage funds are attracting the attention of investors as they can also be an alternative to short term debt funds which offer better tax efficiency. But after the budget of 2018-19 levied 10% tax on long term capital gains (LTCG) made the arbitrage funds less attractive. However, the recent defaults in short term debts has once again made the arbitrage funds attractive for investors. 

Learn more about Long Term Capital Gains Tax here.

Features of Arbitrage Funds: Advantages and Disadvantages

Arbitrage funds have several benefits and drawbacks associated with it. One of the major benefits is low risk and is taxed at a lower rate as compared to other investment options. 

Is arbitrage fund safe?

Arbitrage funds are low risk investments because in arbitrage scheme securities are simultaneously bought and sold which closes the window of the risk involved in long term investments. In case there is a risk of low profit in arbitrage trades, the fund invests in debt securities as they are highly stable. Since, Arbitrage funds invest a part of capital in the debt securities, this makes it attractive for investors with low risk tolerance. 

Arbitrage funds are one of the low risk securities that gives a good return even when the market is highly volatile. Since, volatility leads to uncertainty among investors, the investors have a reason to believe that the differential between the cash and futures markets will increase when the prices are unstable. A highly stable market means individual stock prices are not exhibiting much change. When markets are calm, the stock prices do not exhibit much change in the future as compared to the current prices. 

Risk in Arbitrage Mutual Funds
Risk in Arbitrage Mutual Funds
Image by Gino Crescoli from Pixabay

If an investor wants to benefit from a highly volatile market, then investing in an arbitrage fund is a good option as they offer a good return without taking too much risk. 

Learn about mutual fund riskometer here.

Are arbitrage funds tax free?

The answer to this question is “No”. Arbitrage Funds are taxed at the levels of equity mutual funds.

In arbitrage funds investment managers invest both in equity funds and debt funds, however they primarily invest in equities and therefore are taxed as equity funds. If one holds shares in an arbitrage fund for a long term, then the gains you received are taxed as long-term capital gains. The long-term capital gains are taxed at 10% as compared to the other ordinary income tax rate. 

There are several disadvantages that need to be considered while looking for investing in arbitrage funds. Some of the major drawbacks include cost of investment and investment horizon. 

Cost of Investment

While evaluating an arbitrage fund, cost is an important factor. These funds charge an annual fee from the investors, based on a percentage of the funds’ overall assets often referred to as an expense ratio. Expense Ratio comprises the fee of the fund managers and charges of fund management. 

Can arbitrage funds give negative returns?

Arbitrage funds incur a high turnover ratio and a substantial transaction cost as they are frequently traded. Additionally, to discourage investors from exiting early, the fund levies an exit load for a period of 30-60 days which leads to an increase in the expense ratio. This further leads to a decrease in investors’ take-home returns. 

Investment Horizon

As we have already discussed that arbitrage funds charge exit loads therefore, it is suitable for investors who are interested to stay invested for at least 3-6 months or having a short or medium term horizon of 3 years to 5 years as returns of arbitrage funds are dependent on the market volatility. In arbitrage funds we are mainly dealing between the differential of the cash market and futures market. So, in the absence of market volatility, arbitrage funds may not provide the returns that the other funds may provide us over the same period. 

Which is the best arbitrage fund?

The best arbitrage mutual fund would be the one which can take advantage of the market volatility by buying a stock in the cash market and selling it at a higher price in the futures market. The below are the top 5 arbitrage mutual funds that the investors can choose to invest in. 

1. EDELWEISS ARBITRAGE FUND DIRECT GROWTH

It is a hybrid type of mutual fund in India with an annualized return of 6.96% in the last three years and have outperformed other similar funds with a return of 7.16% in the last year. The fund carries a moderately low risk and the Asset Under Management of Rs 2387 crores. Minimum lumpsum investment amount required to invest in this scheme is Rs. 5000 and SIP investment in the scheme is Rs 500.

2. KOTAK EQUITY ARBITRAGE FUND DIRECT GROWTH

It is also a hybrid type of mutual fund in India with an annualized return of 6.7% in the last three years and a return of 6.5% last year. The fund carries a moderately low risk and the Asset Under Management of Rs 10580 crores. Minimum lumpsum investment amount required to invest in this scheme is Rs. 5000 and SIP investment in the scheme is Rs 500.

3. NIPPON INDIA ARBITRAGE FUND DIRECT GROWTH

It is also a hybrid type of mutual fund in India with an annualized return of 6.94% in the last three years and a return of 6.68% last year. The fund carries a moderately low risk and the Asset Under Management of Rs 6821 crores. Minimum lumpsum investment amount required to invest in this scheme is Rs. 5000 and SIP investment in the scheme is Rs 100.

4. ADITYA BIRLA SUN LIFE ARBITRAGE FUND DIRECT GROWTH

This popular fund has an averaged at 6.67% in the last three years and returned 6.64% last year. The fund carries a moderately low risk and the Asset Under Management of Rs 3004 crores. Minimum lumpsum investment amount required to invest in this scheme is Rs. 1000 and SIP investment in the scheme is Rs 1000.

5. L&T ARBITRAGE OPPORTUNITIES FUND DIRECT GROWTH

It is also a hybrid type of mutual fund in India with an annualized return of 6.67% in the last three years and a return of 6.64% last year. The fund carries a moderately low risk and the Asset Under Management of Rs 506 crores. Minimum lumpsum investment amount required to invest in this scheme is Rs. 5000 and SIP investment in the scheme is Rs 500.

As discussed above, arbitrage funds are a hybrid fund i.e., it is not a 100% equity arbitrage fund. Funds invest a part of the scheme’s assets in debt securities. Thus, these debt securities may give negative returns in a short period on the account of being valued on a Marked to Market basis.

The arbitrage funds are charged with management fees and other expenses including the exit load. This charge is incurred for running the fund and it may yield a negative return. It is also possible that the portfolio return is Nil on any given day, but due to the expenses incurred for running the fund, the fund return may show a negative return.

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