What are Arbitrage Funds

Arbitrage is an opportunity to benefit from price differences of a given security in two different markets: the spot market and the derivatives market.  Fund houses use this tactic to generate returns where alternative opportunities like liquid or call rates offer lower returns.

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How does it work?

Essentially, these funds don’t take any directional bet on equities and just lock in the spread available between the cash and futures markets. The returns depend on the spreads one can make between the cash and futures position.

The fund manager buys a stock for INR 100 in the cash market and sells futures of the same stock in the derivative market for INR 108. The INR 8 difference in the cash and future prices will be the profit of the fund from this transaction which is realised on the day of the expiry of the futures contract (last Thursday of every month) when prices converge, and the positions are squared up. The reverse transaction is also possible where the fund buys futures and borrows stock via the Securities Lending and Borrowing scheme to do the delivery and generate returns.

Note that this profit stays irrespective of the stock movements – whether the price moves up or down, the difference in the price is locked by the fund when it was originally invested.

The fund manager will do this trade only if it meets the required return criteria. If it doesn’t meet the return requirements, the money would be invested in short-term debt papers from that mutual fund house.

Over the past year, most of these funds have generated returns in excess of 6% which make them very attractive on a post-tax basis for investors seeking safe investment with higher yields.

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Tax Treatment

Since these funds maintain an average equity exposure of more than 65%, they get the same tax treatment as equity funds. Short-term gains are taxed at 15% while long-term gains (holding period of one year or more) are at 10%. Compared to this, deposits bonds and debt funds are taxed at marginal rates in the short term and higher rates of 20% in the longer term- making returns from these very attractive especially in the higher tax brackets.

Ideal Time Horizon

Most arbitrage funds have a one-month exit load as the arbitrage cycles are at least a month to 3 months. To prevent sudden outflows, investors are disincentivised from withdrawing too quickly. Over slightly longer horizons, volatility evens out because most of the futures and options expire by that point.

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