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Arbitrage is the process of simultaneously buying and selling same security in different market segments to profit from a price differential. A type of mutual fund that follows a similar approach as mentioned above is the Arbitrage fund. It aims at generating returns from different segments of equity markets (cash and derivative). It is a technically executed investment strategy to make risk free profits from the pricing difference of the same securities in two different market segments. Which means that the profit is almost known (and is marginal) before executing it. And because of this, the product is relatively safe even though it uses the equity markets for earning returns. A portion of the funds are also invested in short-term fixed income securities for liquidity and to generate returns particularly during the period when the arbitrage opportunities are less.
Advantages of Arbitrage funds
- Low Risk: One of the primary benefits of investing in an Arbitrage fund is that these funds carry lower risk. Owing to the securities bought and sold simultaneously, the risk associated with long-term investments is negligible.
- Tax Efficient: Arbitrage funds gains are taxed under equity taxation making it quite attractive. It also carries the ability to outperform debt funds in certain scenarios. As per prevailing tax rules (March 2022), the short-term capital gains (holdings < 1 year) are taxed at 15%. And the long-term capital gains (holdings > 1 year) above Rs 1 lakh (tax free below ₹ 1 Lakhs) in a financial year are taxed at 10% only.
- Time Horizon: Arbitrage funds can be suitable investment horizon of as low as 6 months to a couple of years.
Arbitrage Funds have practically no risks. Investors should understand that the fund aims to earn returns out of the pricing differences of securities arising primarily due to market volatility. Due to this, they may not look attractive in stable market conditions or an extreme condition when there are no arbitrage opportunities. Also, the portion invested in debt securities might be subjected to credit risk in extreme scenarios. However, the fund manager ensures to choose high quality and credit worthy debt securities to avoid this risk.
Who should Invest in Arbitrage Funds?
Investors need to ensure that their financial goals are in line with the fund’s investment objective. Arbitrage funds are ideal investment instruments for an investor with a short-term (6 months) to medium-term (1 – 3 years) horizon also. Particularly for corporates/institutions, arbitrage funds are attractive option considering its tax implications. Individuals can invest a part of their emergency fund in these or also use it to build one through SIP route. For those who are in the highest tax bracket, this can be considered as an option for traditional products if they have an investment time horizon of 1 to 2 years. It is recommended to consult an expert to understand its suitability before you take an investment decision.
Shreedhara is the Founder & Director of Ara Financial Services Pvt. Ltd. He has an experience of over 2 decades in Financial Service Industry with majority of it in guiding individuals and institutions on their investments requirements.