Arbitrage is the opportunity to benefit from price inefficiencies between two different markets. Arbitrage funds don’t bet on stocks rising or falling, they just lock in the spread available between the cash and futures markets.

The returns depend on these spreads which are typically close to the interest rate prevailing in the broader economy. The arbitrage activity of the fund involves transaction costs such as paying brokerage, securities transaction tax, service tax and other levies. However, these costs are charged at the fund level and are deducted from the NAV of the fund. You do not have to pay them on redemption of your units.

Taxation

Arbitrage funds technically satisfy the requirement of 65% investment in equities (although in reality, this exposure is cancelled out by their derivative holdings) and are classed as equity funds under the Income Tax Act. As a result, their returns are tax free if the fund is held for more than a year and taxed at 15% if held for less than a year. Dividends from these funds are also tax-free in your hands.

Risks Factors Involved

1) Exit Load Risk: Almost all arbitrage funds have an exit load of 60-90 days, unlike liquid mutual funds.

2) Arbitrage Risk: The arbitrage opportunities may be hard to spot or may be too small for the fund to deliver high returns on. The fund may not efficiently capture the opportunity in question.

3) Liquidity Risk: Unlike Liquid Funds, redemptions in Arbitrage Funds take T+3 days to reflect in your bank account (T is the date on which you have given your redemption order).

Performance

The returns of arbitrage funds (though classified as equity funds) are relatively modest and comparable to the returns on liquid funds. However, their favourable tax status makes them good investments for time horizons of one year or less. Debt funds with similar returns will be taxed as per your slab, giving you a much lower post-tax return if you are in a high tax bracket.

We give you the returns of some of the best performing arbitrage funds over the past three years in the table below.

Arbitrage Funds        1 Month 3 Months 1 Year 3 Years
Kotak Equity Arbitrage Fund 0.52% 1.62% 6.54% 7.14%
L&T Arbitrage Fund 0.51% 1.61% 6.61% 7.24%
Arbitrage Fund Category 0.45% 1.46% 5.97% 6.65%

(Source: Morningstar, Data as on 10th January 2018)

Author
Debendra Das

The author is a private wealth manager and financial advisor. The views are his own. Feedback to this article may be sent to contact@rupeeiq.com.