Imagine you have some colourful candies, and you notice that in one store, they’re selling for one shiny sticker each, but in another store across the street, they’re selling for two shiny stickers each. So, what do you do? You quickly run to the store where they’re cheaper, buy a bunch with your stickers, and then run to the other store and sell them for more stickers. That’s kind of like what arbitrage is. Arbitrage funds work a bit like this. They keep an eye out for situations where they can buy something for a low price in one place and sell it for a higher price somewhere else. It’s like finding a good deal and making a little profit from it.
Arbitrage Funds are like special teams in the investment world. They look for differences in prices of things like stocks or assets in different places, like two different stores or markets. When they find something cheaper in one place and more expensive in another, they quickly buy it where it’s cheap and sell it where it’s more expensive. They make money from the difference in prices.
But here’s the catch: they don’t wait for things to change in value over time like regular investors do. Instead, they focus on making quick moves to profit from the price differences. If they can’t find any good deals to make money from, they might invest in other things temporarily until they spot another opportunity.
How do arbitrage funds work?
Certainly! Let’s delve into the two scenarios where arbitrage opportunities exist:
Scenario #1: Price difference between exchanges
Imagine the stock of Reliance Limited is priced at ₹2,946 per share on the Bombay Stock Exchange (BSE) and ₹2,948 per share on the National Stock Exchange (NSE). When the fund manager of an arbitrage fund identifies this gap, they act swiftly. They buy shares from the BSE and simultaneously sell them on the NSE. This simple move enables them to pocket a profit of ₹2 per share (after accounting for transaction costs) without exposing themselves to any risks.
Scenario #2: The price difference between the cash and futures markets
Now, consider Reliance Limited’s share trading at ₹2,948 in the cash market and ₹2,971 in the futures market. In this scenario, the arbitrage fund manager capitalises on the price differential. They purchase shares from the cash market and simultaneously create a futures contract to sell the shares at ₹2,971. As time progresses, they execute the sale in the futures market, locking in a profit of ₹23 per share (accounting for transaction costs) without bearing any risks.
These examples illustrate how arbitrage funds exploit pricing inefficiencies in markets to generate profits through strategic and risk-controlled trading manoeuvres.
Benefits of investing in arbitrage funds
Low risk – Arbitrage funds entail minimal risk for investors because securities are bought and sold simultaneously, and there’s little exposure to market fluctuations compared to longer-term investments. Additionally, these funds often invest in stable debt securities, further reducing risk and appealing to risk-averse investors.
Thriving in volatile markets – Arbitrage funds excel during periods of market volatility. When market prices fluctuate, the price differences between cash and futures markets widen, providing ample opportunities for arbitrage strategies to generate returns. Conversely, in stable markets, where stock prices remain relatively constant, these funds can still benefit.
Suitable for cautious investors – Arbitrage funds are well-suited for cautious investors seeking to benefit from market movements without assuming excessive risk. By capitalising on short-term price differentials, these funds offer a conservative approach to investing in the dynamic financial markets.
Favourable tax treatment – Despite primarily investing in equities, arbitrage funds enjoy favourable tax treatment similar to equity funds. Profits derived from holding shares for over a year are subject to lower capital gains tax rates, which are typically more advantageous compared to ordinary income tax rates.
Potential for higher returns – While arbitrage funds are relatively low-risk investments, they still have the potential to deliver attractive returns, especially during periods of market volatility or when there are significant price discrepancies between related securities or markets.
How does taxation work in arbitrage funds?
Regarding taxation, arbitrage funds are subject to the same tax treatment as equity funds. This is because fund managers allocate a portion of the funds to equities and debt. The tax treatment remains consistent as long as the equity exposure remains below 65%. Taxation on arbitrage funds depends on the holding period of the units:
Short-term capital gains (STCG) tax – This tax is applicable to units of arbitrage mutual funds sold within a year. The tax rate for short-term capital gains is 15%.
Long-term capital gains (LTCG) tax – For units held for over a year, long-term capital gains tax applies. Investors enjoy a ₹1 lakh exemption on long-term capital gains per financial year. Any gains exceeding ₹1 lakh are taxed at a rate of 10% without indexation benefits. Given this, investors in higher tax brackets may find arbitrage funds more attractive than debt funds.
It’s worth noting that the taxation on debt mutual funds underwent changes effective April 1, 2023. The benefits of long-term capital gains from debt-based investments (with less than 35% equity allocation) have been eliminated. Both short-term and long-term gains from debt mutual funds are now taxed according to the income tax slab rate.
To conclude, in your overall portfolio allocation, equity serves as the growth component, while debt offers stability and funds for short-term cash flow planning. Within the debt component, a portion may be allocated to arbitrage funds, capitalising on favourable taxation and performance dynamics, provided the returns surpass the break-even threshold with the debt mentioned earlier.
However, it’s essential not to allocate the entire debt component to arbitrage funds. Diversification stands as a fundamental principle of investment. Even though arbitrage funds can exhibit volatility, incorporating debt funds in the portfolio ensures diversification and stability.
