Arbitrage Mutual Funds What to Expect and When to Invest in Them?
Written on Thursday, September 7, 2017
By Viswajeet Parashar - Senior V.P and Group Head - Marketing
Arbitrage mutual fund is essentially an equity fund that aims for low volatility returns by using arbitrage and other derivative strategies in equity markets. They are taxed as equity funds as equity exposure in them is more than 65 percent of the corpus. The holding period, therefore, in them is 12 months and returns are tax-free if units are sold after a year.
The investment objective of the Arbitrage mutual fund is to generate capital appreciation and income by predominantly investing in the following:
a. Arbitrage opportunities in the cash
b. Derivative segments of the equity markets
c. Arbitrage opportunities available within the derivative segment
After making these equity based investments, the balance is invested in debt and money market instruments. Tax
Advantage Over Debt Funds:
Debt mutual funds were once considered tax-effective when compared to bank fixed deposits. The extent of this advantage, however, got little bit reduced when the holding period for long term capital gains tax benefit on debt funds (any non-equity fund), was increased to 36 months from earlier 12 months. Even though the returns in debt funds is close to 12 percent, but pretax (10 percent tax or 20 percent after indexation), the holding period of 36 months might put-off many investors. During early exit i.e. before 36 months, the gains are subject to tax as per the investor’s tax rate.
Example of Arbitrage:
The prices of stocks differ in the cash and the derivate market. This is the arbitrage or the price difference that such funds try to exploit. Illustratively, a stock may trade at Rs 100 in cash market and Rs 103 in the future market. Buying the stock in cash market while simultaneously selling it in the future market will lock in a profit of Rs 3 for the fund manager.
Investment in mutual fund units involves investment risks such as trading volumes, settlement risk, liquidity risk, default risk including the possible loss of principal, as the price, value or the interest rates of the securities in which the scheme invests fluctuates, the value of your investment in the scheme may go up or down. There can be no assurance or guarantee that the arbitrage opportunities may exist at all times in the capital market. The lack of arbitrage opportunities shall not provide an opportunity to the fund manager to exploit price differences in the capital markets. The performance of such funds will depend on the ability of the fund manager to identify suitable opportunities in the cash and derivative market.
The risks involved may still be there, but restricted largely to the derivative market. It’s important that the futures are trading at a reasonable premium for the fund manager to earn a profit. On expiry of the futures contract, the cash and future price coincide thus, leading to positive returns for the investor. The returns to be generated by an arbitrage fund would primarily depend on the price differential between cash and future price of the stock. This situation largely arises when markets are volatile. This could be the reason when it is suggested that such funds work well in volatile market conditions and hardly in a bear market situation.
What to Do?
Go for arbitrage funds only when your horizon is 6-30 months. For a longer period, debt funds will suit. Read the mandate and the objective of such funds carefully before investing in any one of them. Investing in arbitrage funds is not about exploiting the potential of equities. Hence, do not expect returns as that of equity funds. They may suit investors with shorter investment horizon and a better tax adjusted return.