Best Arbitrage Mutual Funds - MF Explorer

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Arbitrage funds

What are arbitrage funds

According to SEBI’s Categorisation and Rationalisation of Mutual Fund Schemes, an arbitrage fund falls under the ‘Hybrid Schemes’ category and follows arbitrage strategy. It is required to have a minimum investment of 65% in equity and equity related instruments.

What is arbitrage strategy?

Arbitrage strategy, in very simple terms, is simultaneously buying and selling the same security in two different markets, to take advantage of the differences in the price of the security between the two markets. While the differences may be very small on a per security basis, they become considerable when transaction volumes are high.  

There are many ways an arbitrage strategy is put to work. It could be simultaneous buying and selling of a stock in two different stock exchanges when the price of the stock is differing on the two exchanges. It could also be buying in the spot market and selling in the futures market. This is among the most commonly-used routes for arbitrage funds.

An oversimplified example of how arbitrage strategy works is when a profit is made by buying it on the exchange where it is cheaper and selling it on the other exchange. Similarly, arbitrage opportunities can also arise between an instrument that tracks an index and the components of the index or the instrument itself on two different exchanges.

How do arbitrage funds work and where do they invest?

Arbitrage funds primarily work with arbitrage opportunities between the cash market (where a transaction is paid and settled immediately like the stock exchange where one buys and sells shares) and the futures market for equities. Futures contracts are a type of derivative instrument. They are standardized contracts to buy / sell a security at a pre-determined price at a specified point in the future. These futures contracts are traded on futures markets.

The arbitrage opportunity arises from the difference in the price of a stock on the cash market and in the futures market.  An arbitrage fund would buy a security on the cash market and simultaneously enter into a futures contract to sell the same security at a future date and more importantly, at a price higher than what it was purchased for. By doing so, the fund has locked-in the profit and hedged its position on the security, thereby covering the risk that the price of the security will fall in the cash market. So it follows that there may be more arbitrage opportunities in a volatile market than in a flat one.

Since arbitrage funds take opposing positions (buying in one market and selling in the other) in the same security, they are able to lock into profits and curtail downside risks. Since arbitrage funds hedge their entire portfolio in this manner, they are not open to equity market volatility. The aim of arbitrage funds is to earn from such mispricing opportunity through low risk. Arbitrage funds do not look to generate returns via capital gains in equity.

Arbitrage funds are required to hold at least 65% of their assets in equities and equity related instruments and this also includes derivatives.

In addition to the equity component, an arbitrage fund will also hold debt and liquid components in its portfolio and these will generate a fixed income.

What is the nature of returns from arbitrage funds?

An arbitrage fund, by taking opposing positions and hedging its equity positions, will lock-in a profit and generate stable returns. When market volatility is higher, there may be more arbitrage opportunities and therefore more likelihood of higher returns for an arbitrage fund. While the upside may be capped in arbitrage transactions, the downside risk will be contained too making it low on risk and return. In general, arbitrage funds are low-risk, low-return funds.  

Apart from this, arbitrage funds also earn interest from their debt and money market holdings.

Due to the strategy followed, and more so due to the nature of returns that arbitrage funds provide (comparable to debt instruments) they are very often alternative options to liquid funds. Since they are taxed like equity funds, they offer a tax advantage in short-term holdings for those in the higher tax brackets. Our article, ‘Arbitrage funds vs liquid funds’ takes an in-depth look at this comparison and is a must-read if this is on your mind.

What is usually the benchmark?

The benchmark index is the index against which the fund’s performance is evaluated. Nearly all arbitrage funds in India benchmark themselves against the Nifty 50 Arbitrage Index. However, there is the one off fund that is benchmarked against the Crisil Liquid Fund Index or the Crisil 1 Yr T-Bill Index.

Taxation

Due to the minimum 65% investment in equity and equity related instruments, arbitrage funds are taxed like equity mutual funds.

  • IDCW distributions are taxed at the hands of the investor at the applicable tax rate.
  • Short term capital gains (holding period less than 12 months) are taxed at 15%. Long term capital gains (holding period of 12 months or more) above Rs. 1 lakh are taxed at 10%.

The tax treatment (as against debt funds where short term capital gains made on redemption of units held for 3 years or lesser is added to the taxable income and taxed at the applicable slab rate and long term capital gains made on redemption of units held for more than 3 years are taxed at 20% after taking advantage of indexation) while at the same time benefitting from returns comparable to liquid funds is another factor that makes arbitrage funds attractive in addition to the low risk that they carry.

Suitability

  • Arbitrage funds suit investors looking to benefit from their superior tax structure when their holding period is a short-term one. Since returns of arbitrage funds are similar to liquid funds, investors in the lowest tax brackets may be better off with liquid funds.
  • Arbitrage funds are not suitable for time periods below 6 months as during this time frame they can see volatility and even negative returns. Arbitrage funds cannot be substitutes for liquid funds for STP purposes.
  • Arbitrage funds increase in attractiveness during periods of market volatility which is when their benefits will be most useful and when there will be mispriced opportunities that can be used to generate returns.

Evaluating arbitrage funds

In evaluating arbitrage funds, several factors need to be kept in mind.

  • The fund manager and his / her ability to find and generate returns from arbitrage opportunities would be crucial.
  • Historical returns as against category average and peers
  • Past performance and ability to contain downside risks
  • How well they managed short term volatility in the past
  • Expense ratios
  • Arbitrage funds also need to be looked at in the context of the prevailing interest rates and the tax bracket that one falls under.

PrimeInvestor can help you evaluate and pick the most efficient arbitrage funds for your portfolio. Here, we help in the following ways:

  • If you already own arbitrage funds, our MF review tool will tell you what we think of the funds you hold or are considering.
  • If you would like to do a little homework on your own, our MF Screener will definitely be handy.
  • Prime Ratings will give you a list of all the arbitrage funds in India, their 1,3 & 5 year returns and our rating of the fund.
  • Prime Funds has picked the best candidates out of all the arbitrage funds that you can consider investing in. It also tells you why we picked the fund and how you can use it in your portfolio.

 

General Disclosures and Disclaimers

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