Arbitrage funds are the funds floated by Mutual Funds with an aim to take advantage of arbitrage opportunities that exist between the cash and the futures market to generate a steady income for the investors. The arbitrage funds take advantage of the mis-pricing between the cash and derivatives market.
How arbitrage funds work?
For example, an arbitrage fund may buy Infosys shares @ Rs1800/share in cash market on 01 April. At the same time, it will sell Infosys shares in the futures market, which would be quoting at about Rs1815. This existing difference is called "cost of carry" in financial parlance.
Let’s say the price of Infosys on the expiry date of the futures contract (last Thursday of every month) is Rs1900. Thus, the fund will make a profit of Rs100 per share in the cash market (Rs1900- Rs1800) and loss of Rs85 in the futures market. (Rs1815 – Rs1900). Here, the important assumption is the cash and futures price remains the same on the date of expiry. The net gain per share is Rs15 after setting off the loss on the futures market.
In case the price of Infosys share drops to Rs1700 on the settlement day. The fund will make a loss of Rs100 per share in the cash market and profit of Rs115 in the futures market. Again, the net gain will be Rs15 per share. This way, the arbitrage funds makes money in all the situations.
Tax Implications for Arbitrage funds:
For tax purposes, arbitrage funds are treated like equity funds. There is no dividend distribution tax, no long term capital gains tax and the short term capital gains tax is at 11.33% compared to the applicable slab rate for debt funds.
Dividend distribution tax – NIL
Long Term Capital Gains tax – NIL
Short Term Capital Gains Tax – 11.33%
Securities Transaction Tax – 0.25%
Return expectations:
The arbitrage funds have given a return of around 9.25% p.a. in the last 6-12 months compared to 7.5% returns for floating rate funds and 7.9% for liquid plus funds. The tax treatment is also favourable compared to the debt funds. The Arbitrage funds are the only equity related funds which have given positive returns over the last 3 months or so.
Risks associated with these funds:
Of course, there is couple of them. First, it is possible that the arbitrage opportunity may not be available for the fund to take advantage off. In those cases, we understand it would act like a liquid fund. The second one is that the logic of the cash and futures price of a stock matches on the contract expiry date may not materialize. In addition there is always a possibility of fund manager not capitalizing on the opportunity and the lack of liquidity to execute arbitrage contracts.
Popular Arbitrage funds in the market:
The following are some of the popular arbitrage funds in the market:
JM Arbitrage Advantage fund, SBI Arbitrage Opportunities funds, Kotak Equity Arbitrage Fund, Standard Chartered Arbitrage Fund Plan B. Each of these funds has given a return of above 9% in the last 12 months.
Suitability of the product:
The Arbitrage funds are suitable for people who want to park funds for a short term of 12 -18 months with reasonable degree of safety and return.
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