Why should investors consider Arbitrage Funds in their portfolio?

Investment options have evolved to allow investors exposure to a two or more asset classes such as equity, debt, and gold under a single unified scheme. Investors may choose a scheme based on their time horizon, risk appetites, and investment corpuses. Despite that, it is common for investors to believe that only liquid funds or putting their hard-earned money in a savings account will help them plan for short-term financial goals.

With the plethora of options available at the investor’s disposal today, investors need to expand their horizon and consider other potentially low-risk investment options. One such solution is ‘Arbitrage Funds’. Arbitrage funds are an important investment tool which investors may use to park their short-term surplus. According to data compiled by AMFI, there are 26 arbitrage schemes in India with net assets under management of Rs 90,745.63 crore as on July 31, 2023.

Understanding Arbitrage Funds

Arbitrage funds are a type of mutual fund that aim to buy and sell securities simultaneously in different markets to take advantage of mispricing opportunities. These funds are hybrid in nature as they have the provision of investing a sizeable portion of the portfolio in debt markets, as well.

Arbitrage funds invest a minimum of 65 per cent of their total assets in equity and equity-related instruments. Due to this reason, they qualify for equity taxation. The balance gets invested in debt and other cash instruments to provide a hedge to the portfolio. Arbitrage funds aim to generate positive returns for investors who are looking for a short-term solution to park their surplus money.

These funds aim to leverage the price differential in two different segments: cash markets and futures market. They buy stocks in the cash market and sell them in the futures market simultaneously, thereby making “locking-in” the price differential, called the spread.

To understand how arbitrage works, let us assume that the equity shares of company ‘A’ trade in the cash market at Rs 100 and in the futures market at Rs 102 (due to price premium). The fund manager buys company ‘A’ shares from the cash market at Rs 100 and plans to sell the shares at Rs 102 in the futures. Towards the end of the month, when the futures contract expires, the prices of both the cash market and the futures market coincide, and the fund manager reverses the trade, thereby netting him the differential.

These funds provide investors with an avenue to park their surplus during high and persistent volatility as the trade positions are hedged against one another, with the aim to generate profits for the investor.

Key benefits of investing in Arbitrage Funds

One of the main advantages of arbitrage funds is that they do not take any directional view on the market. The modus operandi of these funds is very

Simple, to identify spreads in the market and look to “lock-in” till the next expiry. For most mutual fund schemes, predicting returns during volatile market phases becomes a stressful task. On the other hand, arbitrage funds are potentially low-risk securities that tend to flourish well in a highly volatile market as the spreads tend to rise and investors are willing to pay a premium.

Since individual stock prices see significant fluctuations in a volatile market, arbitrage funds use it to their advantage through instantaneous buying and selling in different markets.

Even though these funds are Hybrid in nature, they are eligible for equity taxation. This makes an arbitrage fund a great option in terms of tax efficiency as capital gain tax rates are lower compared to other short term debt investment options. If an investor holds the funds for more than a year, they are taxed as long-term capital gains. They receive a higher tax

Arbitrage funds come with three very distinctive advantages that make them a good investment option for most short-term investors. Even then, investors need to consult with their financial advisors, understand the concept, and the value they will add to the portfolio before even considering investing in them.

(The author is Fund Manager, Axis Mutual Funds)