Arbitrage fund is a type of fund that attracts people who want to generate positive returns with less risk during volatile markets. The returns from these fund can be closely correlated with Debt Fund returns. But before investing in these funds, one needs to understand how they work and if they are suitable for their portfolio.
This type of funds work on mispricing of equity shares in the spot market & future market and it takes advantage of the price differences between current and future securities to generate returns. The fund manager simultaneously buys shares in the cash market and sells it in futures or derivatives markets. The difference in the cost price and the selling price is the return what one earns. Small component of fund asset are also invested into liquid debt securities which also gives little more push to the returns.
Benefits of Arbitrage funds
Low Risk: This kind of fund is not 100% risk-free but carry a very negligible amount of risk. They rely on the mismatch between market prices and are mostly hedged (i.e. net zero exposure to market volatility). These kind of funds offer better returns during market volatility than other short term funds and hence a potential alternative to other safer option like debt funds.
Returns During this low interest rate environment, debt fund returns are taking a beating. Also, if you consider credit risk fund the extra returns is not worth the risk. Arbitrage funds gives around 6-7% returns with potentially lower volatility which is on a tax adjusted basis better than any liquid fund. Why so much tax advantage ?
Taxation One of the biggest advantage of arbitrage funds is tax treatment. Equity funds attract long term capital gains and if gains are up to 1lakh it is said to be tax-free and if above 1 lakh then it is taxed at 10%. Generally, short term gains from equity funds are taxed at 15%. So in this scenario arbitrage funds are a combination of debts funds in terms of returns and it has tax treatment of equity funds with concessional benefits.
- This kind of fund is good for those investors who are risk-averse and want to gain steady returns even in high market volatility.
- Though arbitrage funds have low risks it’s pay-off can be sometimes very unpredictable.
- It is taxed as equity funds
- An investor needs to keep an eye on AUM which can create liquidity problems and may lead to lower returns.
Considering the above factors this category is certainly worth exploring and can be a part of your portfolio where the primary objective is the consistency of returns.