Arbitrage Funds started gaining traction in India when liquid funds gains started getting taxed. I thought of discussing a bit on What are Arbitrage Funds? What investment objective the funds serve?

Taxation and risk are the main factors which concern the investors most. Before 2014, short-term debt funds were considered as best option for risk-free returns from investment in mutual fund. After government reduced the tax benefits for debt funds, Arbitrage funds became popular.

It’s investment strategy to generate a return with less risk and taxation benefits have attracted a large number of investors. Arbitrage Funds gains profit from the difference in price of a security in various markets.

Arbitrage Funds: Things to know before Investing

• The fund’s return is based on the volatility of the market. It doesn’t take any directional call in any stocks or in future market.
• The fund is not a substitute of the debt fund, both have different investment objectives with different risk factors.
• Not all the time arbitrage opportunity is present in market, then at that time it considers increasing the limit of debt securities in the portfolio.

Arbitrage Funds: Taxation

Arbitrage funds are considered as equity funds for tax purpose. So, fund returns earned within 1 year are Short term Capital Gain (STCG). The tax rate on STCG is 15% only. Moreover, Long term Capital Gain i.e. fund returns after 1 year shall be taxed @10% if it exceeds Rs.1 lakh during a financial year.

Arbitrage Funds: Different Investment Objectives

1. A fund’s objective might be to generate income by taking advantage of the arbitrage opportunities that potentially exists between cash and derivative market and within the derivative segment along with investments in debt securities & money market instruments.
2. It might be a blend of value and growth style of investing. Having an objective to generate income through arbitrage opportunities emerging out of pricing anomaly between the spot & futures market, and also through the deployment of surplus cash in fixed income instruments.
3. It can be primarily to generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and the derivative segments of the equity markets. Investing in the arbitrage opportunities available within the derivative segment and by investing the balance in debt and money market instruments.
4. The fund’s objective might be to generate low volatility returns by using arbitrage and other derivative strategies in equity markets and investments in a short-term debt portfolio.
   The fund manager can employ Cash arbitrage strategy in which it pockets the difference in price of stocks between the cash market and futures market. In Index arbitrage strategy it takes equal and opposite positions in index futures and corresponding stock futures constituting the index in proportion to their respective weights in the index simultaneously, to lock in the price difference.
5. The fund’s objective can be to generate income by investing in equity and equity related instruments and take advantage of the price differentials or mispricing prevailing in a stock or index.

Whatever be the objective of the fund, the investment motive remains the same. To leverage the price differentials in cash and derivatives market for generating good returns.