Bank fixed deposits or FDs are one of the most popular savings schemes. But the interest rate on bank FDs are on a decline. For example, SBI's one-year bank deposits currently fetch an interest rate of 6.25 per cent. On top of that, the interest earned on bank fixed deposits are taxable. An arbitrage fund is a type of equity mutual fund that tries to take advantage of the price differential (of the same asset) between two or more markets or market segments. But arbitrage mutual funds are near risk-free in nature though returns are not guaranteed.
How Arbitrage Mutual Funds Work?
1) "Arbitrage Funds typically provide returns capturing the spread in the derivatives and the cash equity markets. The strategy provides a good option to high networth investors who are the higher tax brackets as a suitable parking place for funds," says Manoj Nagpal, CEO of Outlook Asia.
2) Arbitrage funds exploit the difference in the price of a stock between cash and derivatives markets or even different stock exchanges such as BSE and NSE. For example, the price of a stock quotes at Rs. 100 in cash market and Rs. 102 in futures market. The fund manager would buy in cash market and simultaneously sell in futures market to lock in a profit of Rs. 2 per share.
3) Arbitrage funds work well in volatile markets as fund managers are able to capitalize on differences in prices of a stock between the equity market and the futures market. Arbitrage fund managers reduce the risk in equities by hedging them using derivatives.
4) Arbitrage funds increase exposure in short-term debt and liquid instruments when there are no arbitrage opportunities.
Taxation of Arbitrage Funds Returns?
5) Arbitrage funds are categorised as equity funds from a taxation perspective. This gives arbitrage funds the benefit of zero taxes on long-term gains (holding period of more than a year). If the holding period is less than a year, capital gains (short-term) are taxed at 15 per cent.
6) "With bank FD interest rates now moving lower, arbitrage funds are being favored by investors. Arbitrage funds by nature will not have a fixed return and the returns will fluctuate. Thus, arbitrage funds are suitable for savvy investors who understand these implications," adds Mr Nagpal.
8) Since arbitrage funds are categorised as equity funds, dividends from arbitrage funds are tax-free for investors.
9) Arbitrage funds as a category have given a return of 5.9 per cent, 6.9 per cent and 7.3 per cent in one year, three years and five years respectively, according to mutual fund research house Value Research.
10) Arbitrage funds typically charge an exit load of 0.25 per cent if redeemed within 30 days.