All you need to know about Arbitrage Funds

Is there any investment option which can mimic the risk-return profile of a Debt mutual fund and is also a tax efficient one like an Equity oriented Mutual Fund? Do we have such an investment avenue? Yes is the answer.

Arbitrage Funds have the risk-return profile which is similar to Debt funds and they are also tax efficient ones. An Arbitrage mutual fund is similar to say a Liquid Debt Fund in terms of Returns and is like an Equity fund with respect to Tax implications. It is generally a risk-free investment option.

In this post, let us understand – What is the meaning of Arbitrage? What are Arbitrage Funds? How do Arbitrage Mutual Funds work? What is the tax treatment of capital gains on Arbitrage Funds? Arbitrage Funds Vs Debt Funds.

What is Arbitrage?

Arbitrage is the practice of taking advantage of a price difference between two or more markets. This can be done by exploiting the differences in the price of a Financial Security or Asset or Product (goods) by simultaneously buying and selling it in different markets. It is a short-term trading opportunity.

Let’s understand the concept of Arbitrage with an example.

Mr Saravana runs a decent hotel which serves only South Indian Tiffin Items. His hotel is very famous for Idlis. He sells Idli at Rs 10 per piece. The cost price of one Idli is Rs 7. So, he earns a net profit of Rs 3 (Rs 10- Rs 7) for each Idli sold. He is not happy with the quantum of net-profit. He wants to increase his profit margin without increasing the selling price.

One day, he tasted idlis in a near-by Bus stand canteen. The quality and taste of the Idlis are same. But the selling price of each Idli is Rs 5 only (whereas he is selling one Idly for Rs 10). So, he decides to buy Idlis from the canteen at Rs 5 and to sell at his hotel for Rs 10 each. In this scenario, he can make a profit of Rs 5 (Rs 10 – Rs 5).

What are Arbitrage Funds? How do Arbitrage Funds work?

The above practice of buying from one market and selling at a slightly higher price in a different market is called as ‘Arbitrage Opportunity’.

These kind of investment or trading opportunities exist in Financial Markets too. The financial securities like Stocks can be bought in CASH market and can be sold in DERIVATIVES market at a higher price.

For example – Share price of XYZ company can be quoting at Rs 1,000 per share in NSE Cash market (National Stock Exchange) and Rs 1,010 per share in Futures & Options market for the next month. So, an investor or fund manager can buy shares of XYZ at Rs 1,000 and at the same time sells XYZ share in F&O at Rs 1,010. On settlement date (Expiry day), the investor can make a profit of Rs 10. ( A Futures contract is a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future.)

So, Arbitrage Fund is the one which tries to exploit the pricing imbalances (mispricing) which are available in the cash and derivatives markets. The strategy of an arbitrage fund is to trade in Cash & Derivatives market with an aim to generate debt fund like returns.

Another arbitrage opportunity can be when there is a difference in the prices of a Share quoted in the NSE & the BSE.

Portfolio of an Arbitrage Fund

The fund objective of a typical Arbitrage Fund in India is to generate reasonable returns by predominantly investing in arbitrage opportunities in the cash and derivatives segments of the equity markets and by investing remaining balance in debt and money market instruments (like Debentures, Commercial Paper, Certificate of Deposits etc.,).

For example : ICICI Prudential Equity Arbitrage Fund’s investment objective is ‘to generate low volatility returns by using arbitrage and other derivative strategies in equity markets and investments in short-term debt portfolio.’

As of  30th Nov, 2017 this arbitrage fund has a portfolio allocation of 66% in Equity & Equity derivatives, around 22% in Debt Securities, 3% in Money Market Securities and around 6% as idle cash.

Arbitrage funds can be classified as Arbitrage (or) Arbitrage Plus funds depending on the respective scheme investment strategy. Arbitrage Plus Funds’ execute investment strategies that may involve relatively more risk than usual arbitrage funds.

Below are some of the top performing and best Arbitrage Mutual Fund Schemes 2016-17. These are Direct Plans with Growth option.

Best Arbitrage Funds – 2018

I have reviewed the performance of the funds under Arbitrage fund category and have provided the new list in the below table. I have replaced HDFC Arbitrage Fund and IDFC Arbitrage Fund, included Axis Enhanced Arbitrage Fund & Edelweiss Arbitrage Fund.

• The Arbitrage fund category average returns in the last one year was around 5.5% and in the last 2 to 3 years the returns have been around 7%.
• The returns from Arbitrage funds have slightly decreased over the last couple of years. The returns on these funds are mainly dependent on the fund manager’s ability to spot arbitrage opportunities. As more funds and more monies chase the arbitrage opportunities, the returns can reduce. If you observe the AUM of all the funds have increased tremendously in the last couple of years. ICICI Pru Equity Arbitrage Fund’s AUM has increased from Rs 1,000 cr in 2016 to around Rs 11,000 cr in 2017.
  • Continuing with ‘Idli’ example; If hotel customers realize that same quality idlis are available at Rs 5 in the near-by canteen, the profits made by Saravana will surely come down. (or) The canteen owner can increase the price of each Idly and the arbitrage opportunity can vanish from the market.
• The current FD rates for 1 to 2 year tenure are around 6 to 7%. But Arbitrage funds are more tax efficient than FDs. So, if you are planning to invest in FDs (time deposits) for short term, you may still consider investing in Arbitrage Funds.
• Arbitrage funds have given average returns of 5 to 6% in the past one year, while liquid and short-term funds have given around 6.5% and fixed deposits have yielded 6.75%. Investors in the 5% tax bracket might not find this very attractive, but those in the 20% and 30% tax brackets certainly will. In the 30% tax bracket, the post-tax yield of debt funds will be around 4.5% while bank deposits will give roughly 4.75%.  
  • Post-tax returns = Pre-Tax returns * { (100-Tax Rate) / 100 }
• If you decide to invest in an Arbitrage Fund, consider opting for a Direct plan. Below table gives us an idea about why investing in a Direct Plan is better than investing in a Regular of the same scheme. I have provided details on ICICI Prudential Equity Arbitrage Fund here. The returns generate by the Direct Plan is better than the Regular Plan returns. The Expense ratio of the Direct plan is 0.27% and for the Regular Plan it is 0.87%.

(You may like reading : ‘What are Direct Mutual Fund Plans?‘ & ‘Equity Mutual Fund Direct Plans Vs Regular Plans – Comparison of Returns‘)

Taxation of Arbitrage Funds

It is very important that you as an investor should know about the tax treatment & tax adjusted returns of an investment option before making any investment decisions.

From the above Returns table it is very clear that Arbitrage Funds can generate returns which are comparable to Short Term Debt Funds or Liquid Debt Funds and Fixed Deposits. So, what’s special about these funds when compared to Debt Funds or even Fixed Deposits??

For income tax purpose, the arbitrage mutual funds are classified as Equity oriented funds.

• Long Term Capital Gains on Arbitrage Fund
  • If you make a gain / profit on your investment in an Arbitrage Mutual Fund scheme that you have held for over 1 year, it will be classified as Long Term Capital Gain.
  • The long term capital gains on Arbitrage Fund are tax-free. With effective from 1st April 2018, the long term capital gains on Equity funds are taxable @ 10%. (Kindly read : ‘10% LTCG tax on sale of Stocks & Equity mutual fund units‘)
• Short Term Capital Gains
  • If your holdings of an Arbitrage Equity mutual fund scheme are less than 1 year old i.e. if you withdraw your mutual fund units before 1 year, after making a profit, then the profit will be considered as Short Term Capital Gain.
  • The capital gain tax rate of 15% is applicable on Short Term Capital Gains of Arbitrage Fund.
  • Kindly note that if you are in 30% income tax slab rate, the interest income on Fixed Deposits will be charged at 30% (as per your income tax slab rate).
  • The Short term Capital gains on Debt mutual funds too are taxed at 30% (as per your income tax slab rate) if the holding period is less than 3 years.

(Related Article : ‘Mutual Fund Taxation rules.‘)

Important Points to ponder upon before investing in Arbitrage Mutual Fund Schemes

• Arbitrage Funds can generate more and better returns when markets are volatile. The volatile markets can create arbitrage opportunities. But, do not invest in Arbitrage funds with an objective to get double digit returns. The returns at best can be in the range of 5 to 8%.
• These funds can generate better returns if major portion of fund corpus is invested in mid or small cap stocks or derivatives as they can be very volatile.
• If you opt for ‘Dividend’ option, then DDT (Dividend Distribution Tax) is not applicable on the dividend declared by the funds. The dividends received from Arbitrage Funds are tax-free.
• Though these funds mimic debt funds like risk profile but they cannot be considered as pure alternatives to Debt mutual Funds. In a declining interest rate scenario, Gilt Funds or Short-Term Debt Funds or even Dynamic Bond Funds can outperform Arbitrage Funds. In the first half of the 2015, Income Funds or Dynamic Bond funds (Debt funds) & Short-Term debt funds have outperformed the arbitrage funds thanks to the interest rate cuts.
• Kindly note that though these funds are treated as Equity funds w.r.t. taxation, but they may not generate returns like equity funds in the long-term.
• If you are looking for a tax efficient investment option for short term goals (1 to 2 year goals), you can consider investing in arbitrage funds.
• You can invest lump sum amounts in these funds for short-term goals. Systematic Investment Plan (SIPs) in these funds may not really make sense.
• You can consider these funds as one of the saving options when you are building your emergency fund.
• When your Financial Goal Target Year is nearing, you can switch from high risk investment options to these funds which have low-risk & are tax-free (more than 1 year).
• These funds have a very remote chance of generating negative returns. Even in 2008 when stock markets crashed, arbitrage funds gave positive returns in India.
• As these are risk-less opportunities, the returns may not be double digits.
• Arbitrage Funds can be a better choice if you are in the tax slabs of 20 to 30%, when markets are very volatile and when the interest rates are stable or increasing.
• Do watch out for Exit Loads of these funds. They can be higher than the debt funds.
• Arbitrage Funds are not allowed to SHORT in Cash Markets in India. So in a bear market their performances can suffer.
• These funds have high turnover and high transaction costs. (If a fund has 100% turnover, the fund replaces all of its holdings over a 12-month period. This is known as Turnover Ratio.)

Do you invest in Arbitrage Funds? Do you believe that these are good substitutes for Fixed Deposits? Kindly share your views. Cheers!

(Image courtesy of Stuart Miles at FreeDigitalPhotos.net)

(Post Published on : 18-May-2016)