Here’s an insight into the world of arbitrage funds — what you must know before taking exposure in such funds.
HOW IT WORKS
For starters, an arbitrage fund tries to take advantage of price discrepancies for the same asset in different markets. For example, if the stock price of ABC Ltd is quoting at Rs 100 and its future price is Rs 110 in the derivatives market, then the arbitrage fund can buy the stock in the spot market and sell it in the futures market and gain Rs 10.
Put simply, arbitrage funds are fixed income products that are free from equity risk. They are affected by the stock market trend (bullish or bearish) to the extent that the demand for stocks and liquidity in the markets is impacted, which in turn affects the arbitrage opportunities.
Another factor that affects the arbitrage funds is interest rates. Fund managers believe that when interest rates are high, people instead of buying stocks upfront prefer to deal in the futures market as it requires only a fractional payment, hence causing the demand and prices for future contracts to rise. When the interest rates are high, the returns from arbitrage funds are also expected to increase.
PROS & CONS
Many risk-averse people hesitate to enter stock-related investments as they fear capital erosion. Such a risk is, however, substantially less in arbitrage funds because of positions not being open in any way. These funds are usually used as tool for hedging since arbitrage does not involve open positions. Another major advantage of investing in arbitrage funds, point out experts, is that such funds are mostly structured as equity and hence enjoy the tax advantages of equity funds. Like equity investments, they are subject to 10% short-term capital gains taxation (if you sell the fund in less than one year) and no long-term capital gains tax or dividend taxation.
POSITIVE RELATION
You may wonder what kinds of returns are provided by arbitrage funds. The well-known perception of a positive relation between risk and returns holds true in case of arbitrage funds as well. Experts on personal finance believe that you cannot expect phenomenal returns from these funds. In fact, returns in any case would not usually surpass 12% mark. These funds have been providing returns in the range of 8-11% till last year. But due to insufficient arbitrage opportunities in the market and large selling pressures, fund returns have dropped this year.
Arbitrage funds cannot be termed as liquid funds but you can expect steady and consistent returns from them over a period of three-six months. In India, a host of AMCs, including HDFC Standard, IDFC, JM Financial, Kotak, Lotus India and SBI, offer such funds.
WATCH OUT
There are certain other things you should be aware of before taking exposure in such funds. You should know there are only certain arbitrage funds which do not maintain a commitment of 65% exposure in equity at all times. Such funds are termed as dividend arbitrage funds and are guided by dividend funds tax norms.
Hence, it’s important that you read the offer document cautiously before investing. In case of dividend funds, the long-term capital gains tax is 10% (with indexation) and also includes 25% dividend taxation. Other than that, as an investor you should have a basic understanding of arbitrage and be aware of funds’ low risk profile. Many agents misguide on arbitrage fund investments saying these are risk-free, which is not true.
