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.
7) The post-tax return from bank fixed deposits is not that attractive for those in higher tax brackets as interest income is added to one's income as taxed according to the respective slabs. "Arbitrage funds provide a good option to high networth investors who are the higher tax brackets as a suitable parking place for funds," says 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.