Investors looking at low-risk options to invest their money for short term generally look towards the liquid funds route. But now people are gradually warming up to the idea of arbitrage funds. Arbitrage funds are taxed at much lower rates and therefore become an attractive alternative to liquid funds.
Arbitrage Fund: An Overview
It is a type of mutual fund which delivers profits by taking advantage of mispricing of a particular security across different exchanges, or between cash & futures markets. Arbitrage funds are safe as they hedge their entire stock holdings. The returns generated by arbitrage funds depend on the volatility in the equity market and the prevailing short-term rates in the money market. Generally, higher the equity market volatility, higher is the return
How do they function?
Let us understand with the help of an example. Assume that XYZ Fund acquires 100 shares of Company A for ₹50 on October 15, 2019. Simultaneously the fund manager short sells 100 futures of Company A for October 2019 expiry at ₹56. This locks the selling price for A at ₹56 while purchasing it at ₹50 in the spot market. This way, the fund has hedged its position in A. If the fund manager holds this position until the expiry date, the fund will earn a guaranteed ₹600 as profits irrespective of the market price of A on the expiry date.
In what situation do they score over liquid funds
It is their tax-efficiency that makes arbitrage funds a superior option to liquid funds or other short-term debt funds. Since they are taxed as equity funds, arbitrage funds tax short-term capital gains (STCG) at 15% as compared to 30% for debt(liquid) funds depending upon the tax bracket of the investor. The STCG incidence of 15% can also be circumvented if investors chose Dividend Reinvestment option. This way, actual taxation shall get reduced to 10% (Dividend Distribution Tax) instead of STCG of 15%.
Arbitrage funds are well-suited for the investors in the 20 percent or 30 percent tax bracket looking to park their money for short term (3-35 months), without taking unnecessary risk