Are Arbitrage Funds a better alternative to Liquid Funds?

18 FEBRUARY, 2021

Equity markets have seen large fluctuations in valuation over the last year as the pandemic brought about significant changes in the market outlook. While markets are once again in the positive and economic activity is showing signs of improvement, it is yet to stabilize, indicating that there may still be some amount of uncertainty to come.

In times of volatility and uncertainty, investors have always looked towards debt as a better option to provide steady and reasonably secure returns. For short term debt based investments, liquid funds have been considered the default option. However, another opportunity to take advantage of short term volatility in the market has emerged in the form of Arbitrage Funds, which are focused on providing lower volatility through the arbitrage concept for equity markets.

What are Arbitrage Funds?

By definition, arbitrage is the act of taking advantage of the price disparity between two markets for the same product. For example, buying a product from one location and selling the same product in the other. Arbitrage Funds work on this principle, taking advantage of the price disparity between the cash market and the futures market.

How do Arbitrage Funds work?

Such funds invest predominantly in arbitrage opportunities in the cash and derivative segments of the equity markets with balance exposure in debt and money market instruments.

They invest their money in acquiring equities in the delivery market, and by setting up a trade for the same at a later date through the futures market or vice versa. For example, a fund might buy shares of a Company A at Rs. 100, and set up a future sale at Rs. 101.5. Usually this happens almost simultaneously and the fund completes the transaction and accrues the profit. Another potential option could be to buy from one stock exchange and sell on the other for marginal gains in price, taking advantage of the price variation between the two markets.

Tax treatment

The Arbitrage Funds shall predominantly invest 65% or more of total proceeds of funds in equity shares of domestic companies and the rest in short-term debt instruments. Arbitrage Funds are treated on par with other equity Mutual Funds, and taxed accordingly on short-term and long-term capital gains at 15% and 10% respectively on the basis of period of holding. Therefore, they represent a suitable investment opportunity for tax payers in higher tax brackets in times of volatility, with a possibility of providing a respectable post tax return.

Kindly note that the tax benefits described above are as available under the present taxation laws and are available subject to conditions. The information given is included for general purpose only and is based on the law and practice in force in India and the client should be aware that the relevant rules or their interpretation may change. As is the case with any investment, there can be no guarantee that the tax position or the proposed tax position prevailing at the time of an investment in the scheme will endure indefinitely. In view of the individual nature of tax consequences, each unitholder is advised to consult his/her own professional tax advisor.

Ideal investment strategy

Investing in Arbitrage Funds may provide better returns when the investment is in a single installment rather than through SIPs. This is primarily due to the nature of the fund, where equities are bought and sold within the same contract/periodic cycle, rather than being held long term like traditional diversified Equity Mutual Funds. Therefore, the returns are usually better with a lumpsum investment.

Since these funds work on the futures contract cycle, they have a higher expense charge as fund management is very dynamic in comparison to other equity funds. For this reason, there is a significant exit charge for short-term liquidation, i.e. less than 3-6 months. This would reduce any gains should the investor wish to liquidate within a short period. The best strategy for such funds therefore would be to buy them for durations of 1-3 year. Such funds also do not have any lock in period, hence making entry and exit easy.

This category of funds is suitable for individuals looking to invest a lumpsum for a short period of time, but with a lower tax leakage as compared to liquid funds. However, investors need to keep in mind that liquidation of these funds can take slightly longer, i.e. 3 days as compared to liquid funds which pay out within a day.

Recap

  1. Arbitrage Funds are low volatility funds designed to leverage arbitrage through price differences in the cash and futures markets, or between two markets where these equities are traded.
  2. They represent a suitable short-term investment option for investors looking to make a one-time investment in the market with low risk and reasonable returns
  3. Such funds are taxed at the same rate as Equity Mutual Funds, i.e. 10% tax liability if held for over a year.
  4. Arbitrage Funds aim to offer a 4-5% return on investment on an annual basis and are an alternative to liquid funds which provide low post tax returns

Let’s look at the Arbitrage Funds recommended by Kotak:

Arbitrage Funds

AUM (in Crs)

Exit Load

Annualised (%)

3M

6M

1Y

ICICI Prudential Equity - Arbitrage Fund

9,441

Within 1M: 0.25%

2.76

3.03

3.92

IDFC Arbitrage Fund

6,670

Within 1M: 0.25%

2.86

2.97

3.47

Kotak Equity Arbitrage Fund

14,908

Within 30D: 0.25%

3.12

3.29

4.02

L&T Arbitrage Opportunities Fund

2,737

Within 1M: 0.5%

3.02

3.54

4.44

Tata Arbitrage Fund

2,814

Within 30D: 0.25%

3.18

3.42

4.62

UTI Arbitrage Fund

2,969

Within 21D: 0.25%

2.91

3.09

4.01

Data as on 13th Jan, 2021 | Source: MFI Explorer

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

Kotak Mahindra Bank Limited, AMFI Registered Mutual Fund Distributor. AMFI Registration Number (ARN) 1390.

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Disclaimer: This Article is for information purpose only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. Bank make no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Newsletter. The information contained in this Article is sourced from empaneled external experts for the benefit of the customers and it does not constitute legal advice from Kotak. Kotak, its directors, employees and the contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein.