Recently, markets regulator SEBI has tightened norms for mutual funds, in the wake of the recent credit crisis. It has mandated that liquid schemes must hold at least 20% in liquid assets, like cash and government securities. Also, the securities held by liquid funds will now be valued on a marked-to-market valuation as against the amortization method used earlier. This will bring down the returns of liquid funds in the future. In this new milieu, returns from arbitrage funds are expected to be more attractive than those of liquid funds.
Arbitrage or arbitraging involves buying and selling the same security in different markets to benefit from the opportunity that arises from the mispricing of the security. Generally, equity arbitrage is done by buying in the cash market and selling the same security in the futures market. There are more opportunities for arbitraging when the market is volatile. Many investors think that arbitrage or arbitrage funds are risky as they are equity instruments, but as arbitrage involves taking opposite positions, the net equity exposure is nil. Even though arbitrage is done in equity instruments, the risk and return are similar to that of debt (and more particularly liquid funds) product. Let us understand arbitrage with the help of an example.
An Arbitrage fund is a type of “equity-oriented hybrid fund” which takes advantage of the price difference by simultaneously transacting in both markets (buying in one market and selling the same security in the other market).In arbitrage funds, the fund manager carries out multiple arbitrage transactions of various securities. Arbitrage funds invest in both equity and debt securities. When arbitrage opportunities are not available, these funds may invest in debt securities or money market instruments. So, for all practical purposes, especially in terms of its risk and return profile, an arbitrage fund is more like a debt product that has been placed in the equity basket, simply due to the fact that the underlying products are from the equity market.
Currently, there are 24 Arbitrage schemes available in the arbitrage category. As on 30th September 2019, the Assets Under Management (AUM) of arbitrage funds was₹74,688 crores which is an increase of about 37% as compared to last year.
Arbitrage funds invest in equity and equity-related instruments and hence, are treated as equity funds for taxation purposes, even though they have the character of debt funds. In the case of arbitrage funds, long-term capital gains for a holding period of more than one year in excess of Rs. 1 lac are taxed at 10% and the short-term capital gains tax for a holding period of less than one year is 15%. Arbitrage funds act as a good alternative to short term debt funds for investors in the high tax bracket. This is because, for investors in the high tax bracket, arbitrage funds will have less taxation (taxed at 15%) as compared to debt funds which are taxed at 30% in the short term. The Dividend Distribution Tax (DDT) is applicable at 10% for arbitrage funds, whereas for debt funds DDT is 25%. Hence, investors can opt for the dividend option while investing in arbitrage funds.
Arbitrage funds are suitable for investors in the high tax bracket and with a minimum investment horizon of 6 months. These funds become a safe investment option for risk-averse investors seeking debt fund-like returns. In addition, they also enhance the post-tax returns due to the taxation differentiation.
Investors should note that the performance of arbitrage funds depends on the arbitrage opportunities available in the equity market and any reduction in these opportunities may result in a muted performance. For investors with an investment horizon of 6 months, an ideal investment option is liquid funds or arbitrage funds. The table below compares the returns from liquid and arbitrage funds -
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We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.