Arbitrage Funds – Important Things to Know

Arbitrage funds are unique in the sense that these mutual funds take advantage of price differences in different markets to generate returns. These funds operate on the principle of arbitrage, involving simultaneous buying and selling of assets in other markets to exploit pricing inefficiencies. Arbitrage funds present an attractive option for investors seeking low-risk avenues with returns comparable to fixed-income instruments.  Understanding arbitrage funds, their benefits, and the pros and cons will help investors like you make the ideal investment decision.

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What Is an Arbitrage Fund?

The arbitrage fund is typically a mutual fund that helps investors make a profit out of price differences between the cash market and the future market. The fund manager buys an asset in the cash market and simultaneously sells it in the futures market when the price difference between the two markets is favorable. These price discrepancies arise due to volatility or inefficiencies in the market, and arbitrage funds profit from these opportunities.

Simply put, an arbitrage mutual fund exploits short-term differences in prices between different markets. For example, if a stock is priced lower in the cash market but higher in the futures market, the fund will buy the stock in the cash market and sell it in the futures market, locking in a risk-free profit.

Benefits of Arbitrage Funds

Arbitrage mutual funds come with several advantages, making them appealing to certain types of investors. Here are some of the critical benefits of arbitrage funds:

Low Risk: Arbitrage funds are considered low risk because they benefit from market inefficiencies rather than market direction. Compared to equity funds, they are often less affected by market volatility, making them an ideal choice for risk-averse investors.

Tax Efficiency: One of the significant advantages of arbitrage funds is their taxation. In India, arbitrage funds are taxed like equity funds. This means that if you hold the fund for more than one year, the gains are subject to long-term capital gains (LTCG) tax at a lower rate (10% without indexation). Short-term capital gains (STCG) are taxed at 15%, which is still more tax-efficient compared to debt funds, which attract income tax based on the investor's tax slab.

Here’s a comparison of how an investment of ₹10 lakhs (10 Lacs) at 6% returns (assumed) in a Fixed Deposit (FD), Liquid Fund, and Arbitrage Fund would look post-tax.

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1. Fixed Deposit (FD)

• Return on Investment (Pre-Tax) = ₹10,00,000 x 6% = ₹60,000
• Tax on Interest (30%) = ₹60,000 x 30% = ₹18,000
• Net Return (Post-Tax) = ₹60,000 - ₹18,000 = ₹42,000

Final Amount (FD): ₹10,42,000

2. Liquid Fund

• Return on Investment (Pre-Tax) = ₹10,00,000 x 6% = ₹60,000
• Tax on Gains (30%) = ₹60,000 x 30% = ₹18,000
• Net Return (Post-Tax) = ₹60,000 - ₹18,000 = ₹42,000

Final Amount (Liquid Fund): ₹10,42,000

3. Arbitrage Fund

• Return on Investment (Pre-Tax) = ₹10,00,000 x 6% = ₹60,000
• Tax on Gains (15%) = ₹60,000 x 15% = ₹9,000
• Net Return (Post-Tax) = ₹60,000 - ₹9,000 = ₹51,000

Final Amount (Arbitrage Fund): ₹10,51,000

Returns Comparable to Debt Funds: While arbitrage fund returns are generally modest, they can offer returns that are comparable to debt funds but with lower tax liability. Investors seeking relatively stable returns with better tax benefits may find arbitrage funds more appealing than debt funds.

Liquidity: Arbitrage funds are typically more liquid than other types of investments. Although they may not be as fluid as liquid funds, they still offer higher liquidity than many traditional fixed-income instruments. Typically, these funds give returns within 6 months to 1 year.

Suitable for Short-Term Goals: Due to their low-risk nature, arbitrage funds are ideal for short- to medium-term investment horizons. They can serve as a safer alternative to equity funds during periods of market volatility while still offering better returns than keeping cash in a savings account.

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Understanding the Pros and Cons of Arbitrage Funds

As stated before, arbitrage funds generate profit out of price differences in securities across markets, guaranteeing low-risk returns. While they offer stability, understanding their liquidity constraints and tax implications is essential for informed investing.

Pros of Arbitrage Funds

• Risk-Free Arbitrage
• Better Tax Efficiency
• Market Volatility Benefits
• Diversification

Cons of Arbitrage Funds

• Limited Returns
• Dependent on Market Volatility
• Costs and Expenses
• Liquidity Issues During Crises

The Key Differences Between Arbitrage Funds vs. Debt Funds

A standard comparison for investors is arbitrage funds vs debt funds. Debt funds invest in fixed-income securities like bonds and government securities, which offer stable returns but are taxed based on the investor's tax slab. Arbitrage funds, on the other hand, derive their returns from exploiting price differences and enjoy the favorable taxation treatment of equity funds. While both serve different investment purposes, arbitrage funds are better suited for tax-conscious investors who want to benefit from short-term investments without taking on too much risk.

The Key Differences Between Liquid vs. Arbitrage Funds

Another comparison investors often consider is liquid vs. arbitrage funds. While liquid funds invest in short-term debt instruments and offer higher liquidity, arbitrage funds provide slightly better returns with similar liquidity. Liquid funds are more appropriate for ultra-short-term goals, while arbitrage funds are better for short—to medium-term goals.

Cube Wealth offers real-time market analysis and insights to help you make informed choices between liquid and arbitrage funds that best suit your investment objectives.

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Conclusion 

Arbitrage funds are a low-risk, tax-efficient investment option ideal for conservative investors seeking stable returns without heavy exposure to market volatility. While their returns are not as high as those of equity mutual funds, they provide a safer alternative during turbulent times and are more tax-efficient compared to debt funds. For investors looking to diversify their portfolios with a low-risk, equity-taxed investment, investing in arbitrage funds could be a viable option.

Leverage our expertise and resources in navigating the wealth market. Allow us to guide you in investing in profitable assets like Arbitrage Funds and gaining stable returns.

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