What is an Arbitrage Fund?

Published On: 09-Aug-2020

An Arbitrage fund is a mutual fund scheme following an arbitrage strategy to generate returns for the investors. In other words, it looks out to extract benefits out of the inefficiencies in the equity markets in terms of pricing specific stocks at different prices in different market segments, i.e., cash segment, and futures segment. As SEBI (Securities and Exchange Board of India) has now also allowed for the interoperability for the stock trades across different exchanges, the arbitrage funds in India may also look out for differential pricing of the stocks in BSE and NSE and trade concurrently to generate returns. Such funds enjoy the trust of investors for its inherent benefits of generating risk-free returns, and as on 30th June 2020, such funds carry an AUM (Assets under Management) figure of Rs. 72,079 crores across the industry 

Source - AMFI

What is Arbitrage Funds and How do Arbitrage Funds Work

Features of Arbitrage Funds

•  Equity oriented

Such funds need to invest at least 65% of the portfolio in equities and equity-related instruments. 

•  Hedged Exposures

By the very nature of arbitrage funds, the portfolio will tend to carry hedged exposures predominantly. In simple words, it means that the long exposures for security will be covered with a short position in the futures segment or at another exchange.

•  Insignificant Investment Risk

Since the portfolio does not carry open exposures for equity securities, the investors are exposed to a significant amount of investment risk.    

How do Arbitrage Funds Work?

Arbitrage funds aim to extract the time value of money embedded in the forward prices in the futures segment. Since the forward prices converge with the spot prices on the expiry date, holding opposite positions in two segments may generate reasonable returns for the investors. 

For example, an equity share of ABC Company is trading in the cash segment at NSE at Rs. 100, and the rate of the futures contract expiring after two months is Rs. 101.75. Seeing the difference of Rs. 1.75 as potential returns, the fund manager will buy the shares in the cash market at the prevailing price of Rs. 100, and sell a futures contract at Rs. 101.75 per share. With time, the difference of Rs. 1.75 will slowly reduce to zero, and as the fund manager squares off the position, the fund manager may net off the gain of Rs. 1.75 over two months, irrespective of the movements in the price of the underlying share. 

Similarly, if the price of ABC shares at NSE is Rs. 100 and at BSE is Rs. 101, the fund manager may buy the stock at NSE and sell the same at BSE and generate a risk-free gain of Rs. 1. However, the quantity for the opposite trades must be similar to mitigate the investment risk as only then may be the trades be correlated and linked as perfect hedges to each other. 

Arbitrage Funds Returns

The returns of the investors may get moderated due to the higher transaction costs, higher trading volume and other fund expenses. The fund managers must explore and spot such arbitrage opportunities regularly to generate consistent returns for the investors. Further, in the periods with fewer arbitrage opportunities, the fund manager may also deploy the funds in fixed income securities, while maintaining the minimum equity exposure of 65% as required by the Securities and Exchange Board of India (SEBI) regulation. Such funds have generated an category average return of 4.65% over the last year and even better CAGR returns of 7.16% over 10- year period ( on trailing basis ) . (Source - Value Research Online, data as on 27th July 2020).Considering the risk-free nature of the investment, such returns may be deemed reasonable, as against the prevailing savings bank rates. 

Taxation for Arbitrage Funds 

The increase in the NAV of mutual funds is taxed as Capital Gains in the hands of the investors. Since the arbitrage funds must invest a minimum of 65% of the portfolio in equity and equity-related securities (including derivatives), the funds may be classified as equity-oriented mutual funds, for the purposes of taxation. As such, the appreciation generated by such funds is classified as short-term capital gain (STCG) if the investment period is less than 12 months. Such gains are taxed at 15% (plus applicable cess and surcharge), irrespective of the tax rate applicable to the investor. If the investment period is 12 months or more, the realized gains from arbitrage funds are taxed as long-term capital gains at a rate of 10% (plus applicable cess and surcharge) without any indexation benefit. Further, long term capital gains from equities and equity-oriented mutual funds are exempt up to Rs. 1 lakh a year.

The tax efficiency of arbitrage funds adds to the suitability of such funds amidst the market volatility. The investors may consider investing a part of their investment portfolio in arbitrage funds to cope up with volatile market movements and generate reasonable returns.

Disclaimers: The information set out above is included for general information purposes only and is not exhaustive and does not constitute legal or tax advice. In view of the individual nature of the tax consequences, each investor is advised to consult his or her or their own tax consultant with respect to specific tax implications arising out of their participation in the Scheme. Income Tax benefits to the mutual fund & to the unit holder is in accordance with the prevailing tax laws/finance bill 2020. Any action taken by you on the basis of the information contained herein is not intended as on offer or solicitation for the purchase and sales of any schemes of UTI mutual Fund. Please read the full details provided in SID and SIA carefully before taking any decision.

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