Arbitrage Fund-Short Term Tax Efficient Investment

Arbitrage fund is a category of equity mutual fund that takes advantage of the price difference for shares in cash market and futures of same shares in derivative market. Derivative is a financial instrument that derives its value from an underlying security / asset or group of securities/ assets. The value of a derivative is linked to the value of underlying asset/ security.  Arbitrage is the process of earning profit by leveraging the price difference between two markets for the same security or asset by simultaneous buying in one market and selling in another market. 

How does arbitrage function? 

Take the example of the stock exchanges of BSE and NSE. Consider that shares of Maruti are trading in BSE at Rs. 7450 per share and at Rs. 7410 in NSE. A shrewd investor can take advantage of the price differential by buying Maruti shares in NSE and by simultaneously selling in BSE. Normally, the price difference between two markets occurs as a consequence of high volatility.This price difference may not last long as many investors may try to utilise the opportunity.  Further, the investor has to take care of the commission and taxes to ensure that the transactions results in profit.  In a highly volatile market, arbitrage opportunity arises between derivatives and also underlying securities. 

How does an arbitrage fund generate profits? 

An arbitrage fund take advantage of price differentials between the derivative and underlying share. Here, a fund manager buy shares in cash segment and sells futures of same company in the derivative segment. This transaction will generate profit only so long as the futures are trading at a premium. To minimize the loss of capital, the fund managers avoid naked positions. Hence, each buy transaction in cash segment is nullified by sale transaction of same company in derivative segment. 

Why do arbitrage funds offer opportunity in present Indian market? 

The Indian stock market is now trading at an all time high with corresponding volatility. Further, the country is under-going an election process that lasts for nearly two months. Clear idea on formation of government and future course of action will emerge only by the end of May 2019. In case, change of guards at the centre, further volatility can be expected for more time. As a consequence of all these, more volatility and good opportunity for arbitrage funds are expected in short term, at least for a period of one year. 

Why do investors prefer arbitrage funds? 

Arbitrage funds are basically equity mutual fund schemes and are treated as equity funds for taxation purpose. They invest more than 65% of corpus in equities. The long term holding period specified for debt funds is minimum three years where as that for equity funds is one year.  Hence equity investments can take advantage of lower LTCG of 10% (introduced from April 1, 2018), if they are held for a period of more than one year. Thus arbitrage funds offer highly tax efficient returns.

According to the views of financial planners and wealth managers, arbitrage funds have high safety, as the net position of investment is ‘nil’ because of the simultaneous buying and selling. As mentioned above, arbitrage funds benefit from volatile market and present state of affairs in India indicate a period of high volatility. 

How much is the return generated by arbitrage funds? 

Return from arbitrage funds depends on the arbitrage opportunities between cash segment and derivative segments. More such opportunities arise in bull markets. During last one year, the average return generated is 5.47%. The return generated over last three year period is around 6%. 

However, arbitrage funds may not be able to generate high returns for the following reasons:
a.    Arbitrage opportunity arises in highly volatile markets and may not occur regularly.
b.    Arbitrage funds have started getting more attention from investors. When more funds flow to the arbitrage funds, more schemes and money will be chasing arbitrage opportunities. Hence the price differential will come down affecting overall opportunity for investors.