What is an arbitrage fund?
An arbitrage fund is a mutual fund that generates returns by capitalizing on the difference in prices of securities in different markets by buying and selling them at the same time. Therefore, the risk that the fund is exposed to remains low.
Let us consider an example:
The share price of Tata Consultancy Services is INR 4,010 in the spot market and INR 4,021 in the futures market. The fund will purchase the share in the spot market (market in which securities are traded for immediate delivery) at INR 4,010 and at the same time create a futures contract to sell the share in futures market (market in which securities are traded at a future date) at INR 4,021.
Therefore, they will make a profit of INR 11 (excluding costs of transaction) with a very low amount of risk.
The price difference however will always be small, so a fund manager will have to make multiple trades to register a profit.
Why are investors looking at arbitrage funds increasingly?
Budget 2023 removed Indexation on long term capital gains for debt mutual funds.
For debt mutual funds purchased after 1st April 2023, the taxation will be as per your slab rate. Earlier an investor would pay a tax of 20% along with an indexation benefit.
What does Indexation mean?
In simple words, the government would allow an investor the benefit of inflation in their cost of purchase, for debt mutual funds held for over 36 months.
This would be through a Cost Inflation Index (CII). If you purchased a fund in 2001, (when the CII was 100) for INR 10,000 and sold it in 2021 (when the CII was 301) for a sale price of INR 50,000.
Your cost of acquisition would not be INR 10,000, but INR30,100 as you were getting the benefit of inflation and your capital gain would be INR 19,900 i.e. (50,000-30,100).
This benefit was removed for debt mutual funds and now they would be taxed at an individual’s slab rate.
Does this mean that taxation on debt mutual funds and fixed deposits are the same?
A key difference between debt mutual funds and fixed deposits, is that the interest that an investor will receive on fixed deposits are taxed at accrual. This means that when the interest is due to you (even if it isn’t received in cash), the bank will deduct TDS, or the investor will have to pay tax in their return. While in debt mutual funds, you will pay only on sale of the fund’s unit.
Because of this, fixed deposits end up with a smaller principal and a lower compounding benefit.
What is the taxation on these arbitrage funds?
For mutual funds that hold over 65 percent of their corpus in equity securities, the rate of taxation for an investor would be 15 percent, and if the fund’s unit is held for over 12 months, the rate of tax will be 10 percent (both will also have surcharges and cess).
What kind of investors invest in arbitrage mutual funds?
Investors put their money into arbitrage mutual funds if they have a low-risk appetite.
What kind of returns do arbitrage mutual funds provide?
Arbitrage mutual funds tend to do better in volatile markets and can provide returns of 8-9%. This coupled with the taxation benefits give them the upper hand on debt mutual funds and fixed deposits in these situations.
Are all investors now moving to Arbitrage Funds for short-term/emergency needs?
While arbitrage mutual funds do surpass debt mutual funds in volatile markets, these returns vary and can be lower in more stable markets and even in bear markets. Therefore, investors would need to be careful in their allocations based on their needs.
What do investors need to watch out for while investing in arbitrage funds?
• Exit load: This means that if an investor makes an investment and then needs to withdraw it beforethe specified period of time, he will have to pay a percentage of his Net Asset Value (NAV) as a penalty. This is usually done to protect longer term investors from instability due to short-term buying and selling. Arbitrage funds often have exit loads if withdrawn within a month or 15 days. Debt funds usually do not have such or have far lower exit loads.
• Expense Ratio: This means the percentage of the investment that the fund will retain in order to pay their expenses. Arbitrage funds tend to have higher expense ratios than liquid funds or money market funds which investors generally use to park short term cash.
• Emergency Funding needs: Arbitrage funds can have more volatile returns than debt funds, an investor will need to understand in what duration will he need cash and invest accordingly, investors who can invest for over 3 months could consider arbitrage funds, if not they may just end up paying an exit load or have lower returns.
Investors often keep a portion of their emergency corpus in debt funds or fixed deposits to hedge themselves against this risk.
(The writer is a Chartered Accountant and financial educator with a passion for stocks, corporate finance and tax, looking to make all of India financially literate)
