Arbitage funds, a not so familiar name among investors, have many inherent benefits in its structure. Name sounds quite complex, but this complexity brings along many advantages for investors. This is something where you can get safe return like debt but taxation of equity. Though at one instance I can say that debt is 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 equity market to remain stable. So when you find everything volatile arbitrage funds will support your portfolio. This article is about Arbitrage funds and its benefits.
What are arbitrage funds?
In stock markets there are 2 segments – Cash and Derivatives. Cash segment is where you take the delivery of the share and keep it in your d’mat account. In derivatives segment, investors trade in future and options (F &O). I will not get into details of how 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 position in the future or option 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 funds are those funds which works 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 high return from these Arbitrage funds. I know it sounds complicated, but this is how arbitrage strategy works. Arbitrage funds are equity category funds, but with different approach.
Advantages of Investing in Arbitrage funds
The first and foremost advantage among arbitrage fund is that it gives good return when 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.
The second advantage is that being an equity fund , the returns are tax free after 1 year as it comes under long term capital gain tax and also dividends announced are tax free.
How arbitrage funds has performed in past years
How arbitrage funds are comparable to debt funds
Arbitrage funds generate returns from stock market volatility. Means it will perform best in uncertain times and when stock market is very volatile as it was in last few months and years. Whereas debt funds perform best when there’s scenario of stable or falling interest rates. If one can figure out these opportunities then its fine otherwise from normal investment perspective arbitrage funds has an edge over debt funds (be it short term or long term). The investment objective of arbitrage funds states “ To generate capital appreciaton and income by predominantly investing in arbitrage opportunities in the cash and derivative segments of the equity markets and the arbitrage opportuniries available within the derivative segment…….” ( taken from IDFC arbitrage fund). This clearly shows that it is offering benefit of both equity and debt mutal funds. Where equity funds’ investment objective is to generate capital appreciation and debt funds’ investment objective is to generate income, arbitrage funds offers both.
Category returns comparison of arbitrage funds, short term and long term debt funds
1 year Category returns comparison of arbitrage funds, short term and long term debt funds
3 year Category returns comparison of arbitrage funds, short term and long term debt funds
5 year Category returns comparison of arbitrage funds, short term and long term debt funds
The above comparison must have made clear that from performance angle arbitrage funds has generated returns in line with short and long term debt fund categories. Also arbitrage funds are much more consistent and less volatile.
The main advantage in arbitrage funds as compared to debt funds is the taxation part. Unlike debt funds which are taxable even in long and short term, arbitrage funds will be taxed at 15% in short term and is not taxable after 1 year i.e in long term. So clearly advantageous for one who’s in high tax bracket and want to park for short term.
Other advantage in arbitrage funds is that Dividends announced by arbitrage funds does not attract any dividend distribution tax, whereas in debt funds dividends are charged with 28.325% of dividend distribution tax.
What should investors do?
As I always say that investors should invest as per their risk tolerance, return expectation 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 expectation of fall in interest rates (which we have been expecting for the 2 years), then its possible that you make good money from the same in short term. But when things are uncertain in stock market and even in debt market then arbitrage funds can be a good bet. Do keep in mind that being an equity oriented fund arbitrage funds are not devoid of risks, but yes less risky than pure equity or equity oriented hybrid instruments.