Arbitrage funds – Best bet in volatile markets

what is arbitrage funds

Arbitrage funds, a not so familiar name among investors, have many inherent benefits in its structure. The name sounds quite complex, but this complexity brings along many advantages for investors.

This is something where you can get a safe return like debt but with the taxation of equity. It’s very much visible these days that even the debt mutual funds are also volatile as it depends on interest rate movement, arbitrage funds are something which derives return from equity market volatility.

You will agree with me that when interest rates are getting volatile, you cannot expect the equity market to remain stable. So when you find everything around you getting volatile, arbitrage funds will support your portfolio. This article is about  Arbitrage mutual funds and its benefits.

What are arbitrage funds?

In stock markets, there are 2 segments – Cash and Derivatives.

The cash segment is where you take the delivery of the share and keep it in your Demat account. In the derivatives segment, investors trade in the future and options (F &O).

I will not get into details of how the F&O segment works, but the main objective of derivatives trading is to hedge the risk or volatility of share price movements.

Hedging means controlling or reducing the risk. This is done by taking a position in the future or options market opposite to the position taken in the cash or physical market.

Arbitrage strategy involves taking advantage of price inefficiencies arising out in cash and derivatives segment and Arbitrage mutual funds are those funds that work on arbitrage strategy.

When markets are volatile the pricing in different market segments cannot keep with each other and smart managers spot this difference and make money out of this.

Investors have to understand that where arbitrage strategy limits the loss it limits the gain too. Thus risk is less but one should also not expect a high return from these Arbitrage funds. I know it sounds complicated, but this is how the arbitrage strategy works.

Arbitrage mutual funds are Considered as Hybrid Equity category funds, but with a different approach.

Advantages and Taxation of Arbitrage funds

The first and foremost advantage among the arbitrage fund is that it gives good returns when the market is volatile. When you don’t find well established active equity funds giving returns, you will find arbitrage funds answering the volatility and giving returns.

Please don’t confuse the word Good return with the Long term Equity Return. I would say when equities are negative Arbitrage funds still be into Positive

The second advantage is that being considered as an equity fund, the capital gain tax on arbitrage funds is similar to other equity mutual funds i.e. tax-Free up to Rs 1 lakh (Total gains in the Investment portfolio) and above Rs 1 lakh is charged at 10%. Short term taxation is 15% on the gains. (Read: taxation of mutual funds in India 2020)

Arbitrage Funds Returns Vis a Vis Sensex PR (as on 30.06.2020)

Arbitrage Mutual funds
Source: Morningstar AWS 30.06.2020. These Funds have History of 10+ years as on date of this data

Arbitrage Funds Risk Reward Comparison to Sensex TR

arbitrage mutual funds risk reward
Source: Morningstar AWS 30.06.2020

How arbitrage mutual funds are comparable to debt funds

Arbitrage funds generate returns from stock market volatility. This means it will perform best in uncertain times and when the stock market is very volatile. In other words, you will always see returns coming from Arbitrage mutual funds 🙂

Whereas debt funds perform best when there’s a scenario of stable or falling interest rates.  If one can figure out these opportunities then it’s fine otherwise from normal investment perspective arbitrage funds have an edge over debt funds, especially in the short term, with the benefit of taxation on its side. (Read: Types of Debt Mutual funds in India)

The investment objective of arbitrage funds states     “ To generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and derivative segments of the equity markets and the arbitrage opportunities available within the derivative segment…….” (taken from IDFC arbitrage fund).

This clearly shows that it is offering the benefit of both equity and debt mutual funds. Where equity funds’ investment objective is to generate capital appreciation and debt funds’ investment objective is to generate income, arbitrage funds offer both.

However, in booming equity times and Falling interest times, you will not find it anywhere in comparison to a specific asset class, Like to debt these days. On Equity side definitely it looks good over a long period of time since we have not seen any good return in past many years, but on debt side due to falling rates, the Returns in debt is looking good.

But the major risk that we are seeing these days in debt funds i.e. the Credit or Default risk, makes the arbitrage funds an attractive alternative.

Arbitrage Funds Vs Liquid funds – Risk Reward Scatter Plot

arbitrage mutual funds
Source: Morningstar AWS 30.06.2020

The above chart clearly shows that Risk wise Arbitrage funds are quite safe even as compared to the liquid Mutual funds. However, due to the interest rate movements over a period of time liquid returns may beat Arbitrage but when you are actually playing the game it is the volatility of the portfolio and the funds that impact your heartbeat.  (Also Read: Balanced advantage funds vs. balanced funds)

The main advantage in arbitrage mutual funds as compared to debt funds is the taxation part. Unlike debt funds returns that get added in your total income short term, arbitrage funds will be taxed at 15% in the short term and at 10% on long term gains after 1 year i.e in long term. So clearly advantageous for one who’s in high tax bracket and wants to park for short term.

What should investors do?

I always say that investors should invest as per their risk tolerance and goals targeted. So Investments in arbitrage funds should also be according to the same.

If investors or advisers can figure out some opportunities like the expectation of a fall in interest rates (which we have been seeing for the 2-3 years), then it’s possible that you make good money from the specific positioning in the short term.

But when things are uncertain in the stock market and even in the debt market then arbitrage funds can be a good bet. Do keep in mind that being an equity-oriented fund arbitrage funds is not devoid of risks, but yes less risky than pure equity or equity-oriented hybrid instruments. So, it demands a space in your Total Portfolio but with a time horizon of at least 1year+

Hope this article clears your doubts on Arbitrage funds. Feel Free to ask your questions if any in the comments section.

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