Arbitrage Funds – Things to know before investing
Unlike typical equity funds and hybrid funds, arbitrage funds create returns through the purchase and sale of securities in different markets to get the benefit of price mismatch.
Usually, arbitrage funds buys securities from the stock market and sell the same on futures contracts market at a high price to generate profit from the transaction. Since arbitrage funds are a type of equity-oriented hybrid funds, they also invest in short-term debt and money market instruments.
How Arbitrage Funds work ?
As mentioned above, arbitrage funds take into consideration the different prices of security in a different market for profit generation. The two markets where arbitrage funds deal majorly are cash (stock) market and the futures (derivatives) market.
Unlike the stock market, instead of taking into account the current valuation of securities, the futures market work on the anticipated price if the securities at a future time. The price of a security on the stock market at present times is known as the spot price. The future date of transaction mentioned in the futures contract is termed as the maturity date.
Contrary to a transaction in the cash market, securities purchased on the future market will be delivered to the buyer until the maturity date of the contract. On maturity, the transaction will take place on the pre-decided price specified in the futures contract.
Arbitrage Funds get returns from the difference in pricing of the stock between the stock market and the futures market. If the market is going high, a specified number of stocks are purchased from the stock market and simultaneously sold on the derivatives market. In case the market is expected to see a downfall, then the arbitrage fund will purchase the futures contract at a lower price and sell the equivalent number of shares on the stock market at the current spot price.
Assume that an arbitrage fund purchases 1000 shares of XYZ Company for Rs. 10/share at the beginning of May and simultaneously sells 1000 units of January Futures Contract of XYZ Company for Rs. 12. Now there are 2 possibilities; either share price of XYZ Company will increase by the end of May or it will decrease.
Condition 1 – If the share price of XYZ Company increases
Stock Price at expiry (at the end of May) = Rs. 13
Profit/Loss of the Spot transaction in the stock market = (13-10) x 1000 = (+) Rs. 3000
Profit/Loss of the Futures transaction in the derivatives market = (12-13) x 1000 = (-) Rs. 1000
Net profit for the arbitrage fund = 3000-1000 = 2000
Condition 2 – If the share price of XYZ Company decreases
Stock Price at expiry (at the end of May) = Rs. 9
Profit/Loss of the Spot transaction in the stock market = (9-10) x 1000 = (-) Rs. 1000
Profit/Loss of the Futures transaction in the derivatives market = (12-9) x 1000 = (+) Rs. 3000
Net profit for the arbitrage fund = -1000+3000 = Rs. 2000
In the above example, the arbitrage fund remains profitable irrespective of the direction market moves. However, in reality, the difference between the prices of the futures contract and spot transaction may be a lot less which require more transaction to be carried out in a single day to achieve a good return from an average arbitrage fund.
How Arbitrage Funds perform
Compared to other equity-oriented hybrid funds, arbitrage funds perform well during the market volatility as it creates a difference between the spot price and the futures contract price of equities. However, if the market is less volatile low-risk debt mutual funds may outperform arbitrage funds.
Taxation on Arbitrage Funds
For the purpose of taxation, arbitrage funds are treated as equity and hence, they are taxed at 15% if redeemed or sold within a year of purchase. If you stay invested in arbitrage funds for more than 1 year, you make long-term capital gains which in excess of Rs. 1 lakh are taxed at the rate of 10% without indexation.
Top 5 Arbitrage Funds in India
While choosing to invest in mutual funds, one must analyze the fund from all the possible perspectives. Based on past 1 year returns, we are giving you the following list of top 5 arbitrage funds in India.
|Scheme Name||AUM(Cr.)||Latest NAV||Expense Ratio (%)||1 Month||6 Month||1 Year|
|Kotak Equity Arbitrage Scheme(G)||12043.17||26.58||0.97||9.09||6.11||6.52|
|Reliance Arbitrage Fund(G)||8184.65||19.07||1.04||9.21||6.13||6.64|
|ICICI Pru Equity-Arbitrage Fund(G)||7882.30||24.56||0.95||9.41||5.85||6.39|
|HDFC Arbitrage Fund(G)||3369.99||21.62||0.75||8.38||5.69||5.83|
|Edelweiss Arbitrage Fund-Reg(G)||3013.77||13.81||1.12||8.89||6.10||6.34|