Meaning, Modus operandi, and SEBI mandate of Arbitrage Funds
Arbitrage is the process of simultaneous buying and selling of financial instruments from different platforms, exchanges, or locations to cash in on the price difference (usually small in percentage terms). While getting into an arbitrage trade, the quantity of the underlying asset bought and sold should be the same. Only the price difference is captured as the net pay-off from the trade. The pay-off should be large enough to cover the costs involved in executing the trades (i.e. transaction costs). Else, it won’t make sense for the trader to initiate the trade in the first place.
By entering into the arbitrage the fund manager attempts to profit by exploiting price differences of identical or similar financial instruments, on different markets or in different forms (cash and derivative segment). The fund manager may buy the security in the cash market and sell the security in the derivatives markets (futures) to arrive at a profit from price differences prevailing in both the markets or the fund manager may buy the security on NSE and sell the same on BSE or vice-versa to reap the benefit of difference in market prices of the security. On monthly expiry, the closing price of cash and the futures market always remains the same.
Market volatility is not preferred by the investors, however, the fund managers running the arbitrage funds love the market volatility and arbitrage funds generate very high returns when market volatility is at its peak. High volatility results in higher price differences between different markets i.e cash and derivatives creating more arbitrage opportunities for the fund managers enabling them to derive higher returns for their investors.
As per the SEBI Circular no. SEBI/HO/IMD/DF3/CIR/P/2017/114 dated 6th October, 2017 arbitrage funds have to invest a minimum 65% of the total assets in Equity and Equity related instruments and have to generate returns through arbitrage opportunities existing therein.
Let us understand their modus operandi by the examples
The fund manager buys the shares of XYZ limited in the cash market at 2225 per share and simultaneously sells the future of XYZ limited in the future at 2236 per share, deriving Rs. 11 per share arbitrage opportunity. The below table depicts the profit of the fund manager from the deal in different closing price scenario:
| Particulars | Scenario 1 | Scenario 2 | Scenario 3 |
| Price of XYZ Limited in cash market as on 1st October, 2020 | 2225 | 2225 | 2225 |
| Future Price of XYZ Limited expiring on 29th October, 2020 | 2236 | 2236 | 2236 |
| Price of the share as on 29th October (on the settlement date cash and future market price remain the same) | 2200 | 2225 | 2300 |
| (Loss)/Profit in Cash | (25) | – | 75 |
| (Loss)/Profit in Future | 36 | 11 | (64) |
| Net Gain/(Loss) | 11 | 11 | 11 |
It is evident from the above table the arbitrageur locks their return at the time of entering into arbitrage and the same is not affected irrespective of the price movement of the underlying security if the contract is settled at the maturity.
Taxation of Arbitrage Funds
As per section 112A of the Income Tax Act, 1961 Equity oriented mutual funds are those funds which invest a minimum of sixty-five percent of the total proceeds of such funds in the equity shares of domestic companies listed on a recognized stock exchange on the annual average of the monthly averages of the opening and closing figures of the total AUM of the funds. Hence, the arbitrage funds are classified as equity-oriented schemes under the Income Tax Act, 1961.
Arbitrage funds purchased under the growth option if are held as investments are classified as the capital assets following the provisions of the Income Tax Act, 1961. Short term capital gain arising on transfer of equity-oriented mutual funds are taxed @ 15% while the long term capital gain arising on transfer of equity-oriented funds above Rs. 1,00,000 is taxable @ 10% only. The holding period for the classification of short term capital assets or long term capital assets in the case of equity-oriented scheme units is 12 months. The advantage of such lower taxation with such minimal risk makes the arbitrage funds, the favorite doll for parking short term funds/contingent funds among the smart investors or high tax-paying individuals.
It is having very lower taxation as compared to FDR and liquid funds for investors falling under the 30% tax bracket and post-tax return of these funds supersede the return of FDRs and liquid funds if are held for 1-3 years.
Money is paramount
Every investor while investing in any fund/assets class has the principle of money is paramount in his mind, and he doesn’t want to put his money at stake while chasing the return, arbitrage funds by it’s nature carry the least risk and safety of principal is almost equivalent to short term FDRs and liquid funds, if are held for 1-2 months or more. The lower taxation as explained above makes their post-tax return far better than the post-tax return of the liquid funds or short-term FDRs for a person falling under the higher taxation rate.
Factors to be considered while investing in arbitrage funds
1. In the stagnant market, there may exist fewer arbitrage opportunities which may lower the return of the funds.
2. Arbitrage funds also invest in instruments having the nature of liquid investments carrying the risk of default by the investee enterprises.
3. Sudden pressure of redemptions may force the fund manager to exit the position at low profits/losses which may wipe the returns of the scheme.
4. Most of the arbitrage funds carry the exit load up to 30 days of investing, hence, if funds are withdrawn within 30 days of investment it may cause loss to the investor.
Concluding Remarks: Arbitrage funds are the most suitable mutual funds for risk-averse investors looking to park the funds for short tenor 3-6 months, or parking of contingency funds/emergency funds enabling the investor to reap better returns, providing liquidity and safety of principal.
Disclaimer: All information published here is purely for educational and information purposes only and under no circumstances should be used for making investment decisions. Readers must consult their financial advisor before making any actual investment decisions, based on information published here. Any reader taking decisions based on any information published here does so entirely at its own risk.It is evident from the above table the arbitrageur locks their return at the time of entering into arbitrage and the same is not affected irrespective of the price movement of underlying security, if the contract is settled at the maturity.
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