An arbitrage fund is a type of equity mutual fund that takes advantage of the difference in pricing between the cash markets and the futures or derivatives markets. This kind of fund capitalizes on market inadequacies in order to provide benefits to investors. It exploits market volatility to make it work in its favour so as to provide investors with relatively risk-free returns.
Once the investor decides to invest in an arbitrage fund, another assessment becomes a necessity – which option to pick, growth or dividend? Let us find out how to choose between the two!
There are various possibilities to consider before arriving at a choice. However, it eventually depends on the tax implications as well as financial goals and needs of investors. The type of fund (debt or equity) and the holding period are also of prime importance in this case.
Growth option is usually suitable to investors on the lookout for gradual wealth creation/accumulation. The Net Asset Value (NAV) of the fund increases in this case as a result of compounding. This is similar to the interest earned on FD which in turn gets added back to the FD account. The duration of investment matters too. Investment for more than a year attracts LTCG (long term capital gains); and are hence tax free. This appears more lucrative when wealth building or wealth accumulation over a period of time is the aim. The increase in the holding period of investment makes growth option more beneficial.
In dividend reinvestment option, investor's dividends are directly reinvested instead of providing cash dividends to investors. It is a system of recurring dividend reinvestments. Capital appreciation occurs via multiplication of number of holdings, unlike in growth option where there is a stable increase in the NAV. However, it is significant to focus on duration of investment in this case as well. If you are an investor with regular income or liquidity needs, you should possibly consider the dividend reinvestment option.
Another aspect to think about is the tax implication that will come along basis the decision an investor makes. This is dependent on the type of mutual fund chosen for the purpose of investment. For instance, long term investment (more than a year) in equity funds are exempt from tax and STCG (short term capital gains) are taxed at 15% whereas debt funds involve DDT (Dividend Distribution Tax) to be paid by the fund houses. Additionally, holding period becomes significant when it comes to tax on capital gains. A holding period of less than a year in case of equity fund is considered as short term investment thus attracting a 15% tax on short term capital gain. However, a holding period of less than 3 years is considered to be short term investment in case of a debt fund. Any investment sold within 3 years would lead to a tax as per investor's income tax bracket. Post 3 years, sale of an investment would attract a tax of 20% combined with indexation benefit.
Growth option is generally found to be better than dividend reinvestment for arbitrage funds if the investment duration happens to exceed one year thereby making it appealing to investors looking to accumulate their wealth. Dividend reinvestment could be more beneficial to investors falling in higher tax brackets for those investing in debt mutual funds. Therefore, predominantly growth remains the most preferred option when we look at investment in arbitrage funds.
In a nutshell, ad-hoc and haphazard investing will lead you nowhere. A smart investor is expected to have his/her financial objectives ready and explore along the lines of those objectives. It is wise to invest in a mutual fund keeping in mind individual investor requirements. Be a goal oriented investor only then eventually all the pieces fall into place.