Last Updated on Apr 6, 2022 by Aradhana Gotur

When it comes to investing in mutual funds, you are spoilt for choices. Among other types of mutual funds, arbitrage funds are relatively lesser-known among investors. Let’s understand their meaning, how they work, and how they are taxed.

This article covers:

What are arbitrage funds?

Arbitrary, as a word, means something unrestrained or determined by a chance, rather than a principle or a system. Arbitrage funds take root from a similar situation. At the outset, it may seem to function in an arbitrary manner, but rest assured, mutual funds rarely leave things to chance. An arbitrage fund takes advantage of the changing price of the securities across different markets to buy and sell the securities simultaneously, to pocket the differential. An arbitrage fund may leverage the cash market as well as the derivative markets too to generate returns. 

The volatility of the asset decides the value of the returns. Arbitrage funds help the investor make a profit by capitalizing on the difference in the price of the present and future securities.

Arbitrage funds are essentially hybrid funds – meaning they invest across asset classes like equity and debt in varying proportions. These types of mutual funds appeal to investors who plan to generate revenue out of the volatile equity market but have a portion invested in the safer debt market.

Features of arbitrage funds

Let’s have a look at the key features of arbitrage funds:

  • Arbitrage funds are mutual funds that come with the purpose of providing their investors with a balance of risk and return. 
  • These are actively managed funds and generate profit by trading on different stock exchanges.
  • These types of funds are not affected negatively by the fluctuations in the market prices.
  • They keep their investors stress-free because the buying and selling prices are already known to the fund manager, turning the market uncertainty and instability into a blessing for the investors. 
  • Arbitrage funds help the investors avoid a majority of the risks associated with equity market volatility while giving the investors the opportunity of investing in equity.
  • Another very important feature of arbitrage funds is that they are very popular among investors with low-risk capacity.  
  • When the arbitrage opportunity is low, the fund manager allocates a part of the pooled investor capital into choice debt instruments that would generate a profit and have a high credit quality, like debentures, government bonds and term deposits.

So the money is always working in a safer environment to grow into a corpus over time. Arbitrage funds may be volatile in the short-term, but have historically been returning at par with liquid funds over the long-term.

How do arbitrage funds work?

As an investor, you must only invest in what you understand. That is the primary principle to successful investing. 

Let us understand how arbitrage funds work with the help of a simple example. Let’s say, the equity share of a company XYZ trades in the cash market at Rs 1,500 and in the future market at Rs 1,515. The fund manager would buy shares of this company at Rs 1,500 from the cash market, and immediately set a future contract (in the futures market) to liquidate them at Rs 1,515. When the prices coincide, the sell order of the shares in the future market at Rs 1,515 is executed. This generates a risk-free return of Rs 15 for every share, less the transaction costs. 

In another situation, let us assume the fund manager feels that the prices may fall in future. He capitalizes on the situation and enters into a long contract in the futures market. In such a scenario, he will short-sell your shares at Rs 1,515 in the cash market. At the time of expiry, he will also execute a buy order of the shares at Rs 1,500 in the futures market, to earn a profit of Rs 15 per share and cover his position. 

Another way of working with arbitrage funds is that you have the option of purchasing an equity share of Rs 100 at the National Stock Exchange and liquidating it at the Bombay Stock Exchange at Rs 120 to get a profit without taking any risk.

Who should invest in arbitrage funds?

As we have seen, the primary feature of arbitrage funds is that they encash low-risk buy-and-sell deals in the futures and cash markets. You can easily equate the level of risk involved in these funds with the risk involved in pure debt funds.

Therefore, these funds are best-suited for investors who wish to take advantage of the equity market without having to deal with the high risk associated with it. Thus, if you are someone who is averse to risk but exploring options to generate higher returns than from the debt market, arbitrage funds may be considered and taken advantage of, of the market fluctuations.

Things to consider as an investor

There are certain crucial things that you need to take care of as an investor while investing in arbitrage funds:

  • Risk involved: As there is no second party involved in this trade and it is conducted solely on the stock market, it is free of counterparty risks. You are not exposed to the price fluctuations in equities even when you are selling or buying shares in cash or future markets. However, though it is a safe investment, it is still advisable to be careful while investing in arbitrage funds. Every market-linked product comes with inherent risks. In that sense, arbitrage funds are not risk-free investments. With an increase in the number of people trading in the arbitrage market, the price-differential opportunities tend to reduce and the fund manager would have to invest in different types of debt funds to get low but assured profits. 
  • Return: Arbitrage funds can actually get you decent profit if you are able to pick the right fund to invest in. Traditionally, these funds have given investors 7-8% returns over a time span of 5-10 yrs. Though there is no guarantee on the returns on these funds, they are great, low-risk options in a volatile market.
  • Cost of investment: You will have to bear a cost when choosing to invest in arbitrage funds, known as the expense ratio. It is an annual fee that mutual funds charge towards management of your money. Expressed as a percentage of the assets of the fund, it includes the fund management charges, fund manager fees, administration, research and communication charges, and commissions and brokerages. Also, to discourage investors, the fund, at times, levies an extra load for 30 to 60 days, which would further add to the expense ratio of your fund.

Taxability of arbitrage funds

Arbitrage funds are treated just as equity funds for the purpose of taxation. You make short-term capital gains (STCG) if you stay invested for a time period of less than a year, which are taxable at the rate of 15%. Your gains would be considered as long-term capital gains (LTCG) if you stay invested for more than a year. Provided this amount is more than Rs 1 lakh a financial year, you will be taxed at 10% without the benefit of indexation.

Advantages of arbitrage funds

The key benefits of arbitrage funds are as listed below:

  • Low risk: The primary benefit of arbitrary funds is that they rank very low in the risk-o-meter. The buying and selling rates are already known to the fund manager who is able to manage associated risks. A part of arbitrage funds also goes to debt securities, which are usually very stable.
  • Liquidity and lock-in: There is no long-term commitment involved as the securities are simultaneously bought and sold. However, given the higher exit load charges, it may make sense to stay invested for at least three months in a volatile market period. That said, all funds tend to perform the best over the long term.
  • Taxed as equity funds: Arbitrage funds invest primarily in equities. This is why they are taxed as equity funds and the tax rate is much lower for them than the ordinary income tax rate levied on other types of funds such as gold ETFs or debt funds. 
  • Flourish in a volatile market: Arbitrage funds are the only funds that practically flourish when there is volatility in the market. 
  • Balanced funds: Another benefit of arbitrage funds is that they are balanced funds and are a hybrid of both debt and equity, with a focus on equity, thus capturing the benefits of both asset classes.

Top arbitrage funds

It is suggested to analyse arbitrage funds like any other fund, using various parameters when shortlisting it for investment. You may keep in mind your own risk appetite, financial goals, investment horizon and other qualitative and quantitative measures.

The top arbitrage funds you may like to invest in, based on their performance over the last three years are:

Name of fundReturns over 3 yrs
Nippon India Arbitrage Fund6%
Edelweiss Arbitrage Fund5.93%
L&T Arbitrage Opportunities Fund5.92%
UTI Arbitrage Fund5.89%
Kotak Equity Arbitrage Fund5.88%
Aradhana Gotur