Arbitrage Funds - Meaning, Taxation, Risk, Return, How to Invest

Gaurav Seth
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isVerifiedExpertAuthor is a Zfunds Verified Expert
Gaurav Seth

Arbitrage simply means buying from one market and selling in another market. It is done to get the benefit of difference in the prices of different markets.

For example, the Price of onions in market A is Rs.10/kg and in market B it is Rs.12/kg. So, if someone buys the onion from market A and sells it in market B is known as the arbitraging of onions. 

In simple words, it is an opportunity to pocket the gains from the pricing difference of the same product in different markets.

What are Arbitrage Funds?

Arbitrage funds aim to benefit from the mispricing of equity shares in the future and spot market or the BSE and NSE. It gets the benefit of the different prices of the same security in two different markets. The fund manager tries to get into different arbitrage opportunities in the market to generate returns for the fund and investors.

How do Arbitrage Funds work?

Arbitrage funds pool the investment from different investors and invest in the stock market by finding the suitable arbitrage opportunities.

Let’s take an example: The shares of A company are trading at Rs.500 in the cash market and Rs.520 in the future market. Now, fund managers will buy the shares from the cash market at Rs.500 and enter into a futures contract at Rs.520 of selling the shares at the expiry of the contract. At the time of the expiry, the fund manager will sell the shares at Rs.520 and will make a profit of Rs.20 per share.

Another example can be, the price of share A on BSE is Rs.50 and on NSE is Rs.55. So, the fund manager will buy from BSE & sell on NSE and will make a return of Rs.5. The profit of Rs. 5 will be the profit from arbitrage.

Things to consider before investing in Arbitrage Funds

  1. Risks of Arbitrage funds

Arbitrage funds have less risk associated with them. 

As the price of buying and selling the securities is already known to the fund manager before entering the trade. This makes it a low-risk investment. However, as the trades are executed on the stock exchanges, there is a possibility that sometimes there are very few or no opportunities for doing arbitrage. So, these funds also invest in debt instruments with low-risk characteristics to generate some returns for investors. Overall, we can conclude that the arbitrage funds are considered low-risk investments.

2. Return

Arbitrage funds are a good investment for the investor who wants to generate decent returns with low-risks involved. These funds usually generate a return by using arbitrage strategies in the market. And the returns are generally low as the price differences between markets is not that big always. So, these funds are able to generate moderate returns. Also, these funds invest in debt securities yielding low-risk returns.

As of 12 February 2021, the returns from arbitrage funds for the previous period of 3 years has been in the range of 4.25%-5.50%.

3. Cost of investment

The cost of investment is an important part when analyzing the arbitrage funds. Every mutual fund has an expense ratio that includes management costs and fees for managing, marketing, or promoting the fund. But along with this, the arbitrage funds also incur high trading-related fees because they generally enter into a large number of trades or transactions to gain from the arbitrage and generate returns for investors. This could lead to an increase in the expense ratio of the fund. So before making an investment decision, the expense ratio of the fund should be taken into consideration.

However, the expense ratio should not be given much importance if the performance of the fund has been good as they might be charging a higher expense ratio for delivering consistency & good performance. 

4. Investment Horizon

The suitable investment horizon for investments in these funds could be upto 1-2 years. Also, like other mutual funds, these funds do have exit loads. So, before doing investments in these funds, an investor should take his/her investment horizon into consideration to be aware of the expenses.

Taxation on Arbitrage Funds

Arbitrage funds are treated as equity funds for taxation purposes as investments are primarily made in equity & equity-related securities. Hence, these funds are taxed like other equity funds. The gains from these funds are taxed with Long-Term Capital Gains (LTCG) Tax and Short-Term Capital Gain Tax (STCG) depending upon the holding period of an investor. Following taxation is applicable in the case of different holding periods:

  • If an investor redeems the units within the period of 12 months from the date of investment, the gains from the investment will be treated as STCG. As per the Income Tax Act, 1961, short-term capital gains are taxed at 15%.
  • If an investor redeems the units after the period of 12 months from the date of investment, the gains from the investment will be treated as LTCG. As per the Income Tax Act, 1961, long-term capital gains are taxed at 10%. LTCG tax is only applicable on the gains exceeding Rs. 1 lakh per financial year.

How to invest in Arbitrage Funds via ZFunds?

There are very easy and simple steps to start investing in Arbitrage Funds. Follow the below-mentioned steps to start investing:

  1. Create your free account with ZFunds. If you already have an account with ZFunds, you can simply log in to it.
  2. To create an account, you will be required to upload your identification documents which can include an Aadhar card, pan card, Voter ID card, driving license, passport, or any other document which is issued by the central or state government.
  3. You will also be required to upload your address proof.
  4. After that, you just need to select the best fund which suits you as per your investment horizon and risk.
  5. And, then at last you just need to choose whether you want to do a lump sum investment or start a sip.

After the successful investment, the units will be allotted and investment will be reflected within 2-3 working days in your ZFunds account.

Frequently Asked Questions

  • What are Arbitrage funds?

Arbitrage funds are those hybrid mutual funds which generate returns for their investors by entering into different arbitrage opportunities in the stock market. 

  • How are arbitrage funds taxed?

As the arbitrage funds primarily trade in equity market securities, they are taxed as equity funds. The taxation for equity mutual funds is: 

  • If the units are redeemed within a period of 12 months from the date of purchase, the gains are taxed with STCG(Short Term Capital Gains) tax of 15%.
  • If the units are redeemed after a period of 12 months from the date of purchase, the gains are taxed with LTCG(Long Term Capital Gains) tax of 10% on the gains that exceed Rs.1 lakh in that financial year.
  • Do arbitrage funds give tax benefits?

No, arbitrage funds don’t give the benefit of tax deductions under the Income Tax Act,1961. These mutual funds are not considered tax-saving instruments.

However, these funds offer tax-efficient returns to the investors compared to investments in other savings schemes or FDs because of the applicability of equity taxation.

  • Do arbitrage funds have a lock-in period?

No, arbitrage funds do not have any lock-in period associated with them. But it is recommended to invest in these funds for at least 1 year to generate good returns and benefit from LTCG equity taxation.

  • Where do arbitrage funds invest?

Arbitrage funds majorly allocate their assets in equity & equity related securities and some part in the debt securities.  These funds aim to find the opportunity of arbitrage in the equity securities and invest in those securities to make a profit.

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