What is arbitrage?
Arbitrage simply means buying from one market and selling in another market. This is done to take advantage of the difference in prices of different markets.
For example, the price of onion in Market A is Rs 10 a kg and in Market B it is Rs 12 a kg. Therefore, if someone buys an onion from market A and sells it to market B, it is known as onion arbitrage.
In simple words, it is an opportunity to profit from the pricing difference of the same product in different markets.
What are arbitrage funds?
The goal of an arbitrage fund is to benefit from the future and spot markets or the difference of equity shares in BSE and NSE. It benefits from different values of the same security in two different markets. The fund manager tries to delve into various arbitrage opportunities in the market to generate returns for the fund and investors.
How do arbitrage funds work?
Arbitrage funds pool investments from various investors and invest in the stock market by finding appropriate arbitrage opportunities.
Let’s take an example: A. The company’s shares are trading at Rs 500 in the cash market and Rs 520 in the future market. Now, the fund manager will buy shares from the cash market for Rs 500, and enter into a futures contract of Rs 520 to sell the shares at the end of the contract. At the time of expiry, the fund manager will sell the shares for Rs 520 and earn a profit of Rs 20 per share.
Another example is the share A price of Rs 50 on BSE and Rs 55 on NSE. Therefore, fund managers will buy from BSE and sell on NSE and give a return of Rs 5. A profit of 5 rupees will be the profit earned by arbitration.
Things to keep in mind before investing in arbitrage funds
Arbitrage Fund Risks
Arbitrage funds have less risk associated with themselves.
As the fund manager knows before the price of buying and selling securities goes into trade. This makes it a low-risk investment. However, as trades are executed on stock exchanges, there is a possibility that sometimes there is little or no opportunity to arbitrate. Therefore, these funds invest in debt instruments with low risk characteristics to generate some returns for investors. Overall, we can conclude that the arbitration fund is considered a low-risk investment.
Arbitrage funds are a good investment for an investor who wants to generate good returns with low risk. These funds typically generate returns using arbitrage strategies in the market. And the returns are generally low because the price difference between markets is not always large. Therefore, these funds are capable of generating moderate returns. In addition, these funds invest in debt securities that offer low-risk returns.
As of 12 February 2021, returns from arbitrage funds have been in the range of 4.25% – 5.50% for the previous period of 3 years.
The cost of investment is an important part when analyzing arbitrage funds. Each mutual fund has an expense ratio that includes management costs, fees for management, marketing, or promotion of the fund. But alongside this, arbitration funds also impose higher trade-related fees because they typically enter a large number of trades or transactions in order to benefit from arbitration and generate returns for investors. This may increase the fund’s expense ratio. Therefore, the expense ratio of the fund should be kept in mind before deciding to invest.
However, if the funds have performed well then the expense ratios should not be overestimated as they may charge higher expense ratios to provide stability and good performance.
The period of investment suitable for investment in these funds can be up to 1-2 years. Like other mutual funds, these funds also carry an exit load. Therefore, before investing in these funds, an investor should be aware of the expenses over the duration of his investment.
Taxation on arbitrage funds
Arbitrage funds are treated as equity funds for taxation purposes as investments are made primarily in equities and equity-related securities. Therefore, these funds are taxed like other equity funds. The long-term capital gains (LTCG) tax and short-term capital gains tax (STCG) are levied on the profits from these funds, depending on the holding period of an investor. The following taxation applies in case of different holding periods:
– If an investor reschedules the units within a period of 12 months from the date of investment, the profit derived from the investment will be treated as STGG. As per the Income Tax Act, 1961, short term capital gains are taxed at 15%.
– If an investor remodels the units after a period of 12 months from the date of investment, the profit from the investment will be treated as LTGG. As per the Income Tax Act, 1961, long term capital gains are taxed at 10%. LTCG tax is applicable only on the profit of more than Rs 1 lakh in a financial year.
Frequently Asked Questions
1. What are arbitrage funds?
Arbitrage funds are hybrid mutual funds that generate returns for their investors by entering into various intermediary opportunities in the stock market.
2. How are arbitrage funds taxed?
As arbitrage funds primarily trade in equity market securities, they are taxed as equity funds. Taxation for equity mutual funds is:
If the units are redeemed within a period of 12 months from the date of purchase, STCG (Short Term Capital Gains) tax of 15% is levied on the profit.
If the units are redeemed after a period of 12 months from the date of purchase, LTCG (Long Term Capital Gains) tax of 10% is levied on the profit of more than Rs 1 lakh in that financial year.
3. Do arbitrage funds offer tax benefits?
No, arbitrage funds do not provide tax deduction under the Income Tax Act, 1961. These mutual funds are not considered tax-saving instruments.
However, these funds provide tax-efficient returns to investors compared to investments in other savings schemes or FDs due to the applicability of equity tax.
4. Does the arbitrage fund have a lock-in period?
No, there is no lock-in period in arbitrage funds. But to get good profit and benefit from LTCG equity taxation it is recommended to invest in these funds for at least 1 year.
5. Where do arbitrage funds invest?
Arbitrage funds primarily allocate their assets in equity and equity related securities and participate in certain debt securities. The purpose of these funds is to find an arbitrage opportunity in equity securities and invest in those securities to make a profit.