In the world of mutual funds, it is well known that equity funds enjoy the benefit of lower taxation while debt funds are less risky with better returns. But what if you wished to combine the two and enjoy lower taxation, lower risk and good returns? Your answer would be arbitrage funds.
Arbitrage funds are a unique type of equity mutual funds. They capture the arbitrage opportunity that arises because of the price difference of a stock in cash the futures market.Although arbitrage funds deal with equity and derivatives which are high risk, they follow a strategy that makes them low risk.
In a debt mutual fund you buy a mix of bonds and you are paid a fixed interest over a period of time. The higher the risk, the higher the rate of interest. The bonds are traded in a bond market where investors can buy or sell them. They can also be held until the principal is repaid to the investors. Once the principal is repaid, they mature and cease to exist.
Assessment between the Arbitrage and debt funds:
Return rate: In debt mutual funds, the price of the bond varies every day and is heavily influenced by various factors like market rate, change in interest, life of the fund etc. Hence, sometimes the bond might give negative returns.
On the other hand, arbitrage funds rarely give negative returns because of the way they function. Here is an illustration:
Let us assume that your fund manager buys ABC stock in the cash market. The price of the stock is ₹1200 in the cash market and ₹1285 in the futures market. The fund manager would buy the shares and sell them in the futures market, earning a profit of ₹85. In the last Thursday of the month, the futures expire and the prices of both the markets converge. There are two possible outcomes in this situation:
- The price of the fund would rise to ₹1350 in the cash market:
The stock would gain ₹150 in cash market. Meanwhile, it would lose ₹65 in the futures market (1350-1285). Overall, the investor would gain ₹85 (150-65).
- The price of the fund would fall to ₹1140 in the cash market:
Hence, no matter if the market is bullish or bearish; arbitrage funds will almost always generate positive returns. This is one of the biggest advantages of investing in arbitrage funds.
Liquidity: Arbitrage funds need 3-5 days to be liquefied while in debt mutual funds, liquidity depends on the type of fund.
Taxation:Since arbitrage funds have an equity exposure of 65% or more, they are treated as equity funds for taxation purposes (15% for short term gains and no taxation on long term gains). Additionally, DDT is not levied on dividends.
In debt mutual funds, short term gains are added to your income slab and taxed accordingly. The long term gains are taxed at 20% after indexation.
Time period: Arbitrage funds are meant for short term money, preferably 1 to 3 years. If you are looking for long term investment, debt mutual funds are the best bet. Initially for the first 3 years, arbitrage funds provide better returns. But in the long run, debt funds perform better.
A comparison of the absolute returns between SBI Arbitrage Opportunities fund and SBI Debt hybrid fund from 2013 – 2018:
Arbitrage funds can replace your debt mutual funds as long as your investment horizon expands only for a short term. They carry less risk, good returns and taxation benefits. But over a long period of time, debt mutual funds generate more wealth.