Arbitrage Funds

Arbitrage is the practice of taking advantage of a price difference in two or more markets. For eg: if the price of rice in Mumbai is Rs 25/kg whereas in Chennai it is Rs 30/kg, then there is an opportunity to buy in Mumbai and sell in Chennai. This is a simple example of Arbitrage.

Arbitrage mutual funds are funds that take advantage of similar arbitrage opportunities between the equity spot and futures market. The spot market is where we purchase/sell shares. The futures market is where we trade in contracts to buy/sell shares at a future date.For eg: If one buys a 3 month futures contract to buy Reliance shares, then one is paying a rate today to take delivery of shares that will be delivered in 3 months.

The important point to understand is that the contract in itself can be traded (both bought & sold). The futures price depends on the underlying spot price and the time remaining for the contract to be executed. Towards the closing date of the contract the spot price and the futures price will coincide. The holder of the contract will take delivery of the shares and the final seller is liable to deliver the same. These are the important principles that are made use of in Arbitrage Mutual funds.

Eg: Supposing Reliance spot is quoting at Rs 700, while a Reliance future(for a single share) is quoting at Rs 710. A certain quantity is purchased in the spot and the same quantity is sold in the futures market. A straight profit of Rs 10/share is made on the transaction. At the closing date of the futures contract one needs to deliver the said quantity of Reliance which is already being held and this way the transaction is concluded. This is the simple process that is followed by Arbitrage Mutual Funds. Note: The profit margin will depend on the difference between spot & future prices at entry and nothing else. Also, it doesn’t matter if Reliance had moved up/down during the transactions. The profit is locked at entry.

Arbitrage funds make use of sophisticated computers that capture these arbitrage opportunities as and when they appear in the market.

The advantage of Arbitrage funds are that they are completely risk-free and are independent of the general market movements. The other advantage of Arbitrage funds are that they are treated as equity mutual funds and hence come with all the tax-benefits that equity mutual funds enjoy. The returns are dependent on the arbitrage opportunities available and are usually a small percentage of the total value of the trade. Returns therefore cannot be compared to equity funds over the long term. But, by their very nature it makes sense looking at them as a parking opportunity vis-à-vis debt.

The tax advantages of Arbitrage funds vis-à-vis Debt Mutual funds & Fixed Deposits are highlighted below.

Term	Arbitrage Funds	Debt MF Schemes	Fixed Deposits
Short Term (Less than one year)	Gain taxed at 15%*	Taxed at 30%*	Taxed at 30%*
Long Term (More than one year)	No Tax	Taxed at 10%^	Taxed at 30%*
Dividends/ Monthly Payments	Tax free	Dividend distribution tax @ 28.3125%	Taxed at 30%*

*Investor slab has been assumed at 30%.Cess+ Surcharge not taken into account.

^ can be indexed also.

Comparison of post-tax returns from Arbitrage/Debt/FD. (Short term & Long Term).

Short Term
	Arbitrage Funds	Debt MF Schemes	Fixed Deposits
Invested Amount (Rs)	1000000	1000000	1000000
Return Annualized(Assumed)	9%	9%	9%
Period	6 months	6 months	6 months
Pre-Tax Return	1,045,000.00	1,045,000.00	1,045,000.00
Post-Tax Return	1,038,250.00	1,031,500.00	1,031,500.00

  

Long Term
	Arbitrage Funds	Debt MF Schemes	Fixed Deposits
Invested Amount (Rs)	1000000	1000000	1000000
Return Annualized(Assumed)	9%	9%	9%
Period	1 year	1 year	1 year
Pre-Tax Return	1,090,000.00	1,090,000.00	1,090,000.00
Post-Tax Return	1,090,000.00	1,081,000.00	1,063,000.00

       

As you can see from above there is a clear tax-advantage with arbitrage mutual funds.

The drawback with these funds is that the returns cannot be guaranteed. However, the minimum rate of return required on Arbitrage Mutual funds is 2% less than that required in debt/fd to be equivalent in the short term and 1% for debt MF’s and 3% for FD’s in the long term thanks to the inherent tax breaks on the returns from arbitrage schemes. i.e. even if an Arbitrage scheme is returning only 7%, it can still be compared to debt/ fd’s that are offering 9% thanks to the tax-breaks being offered.

Now, we see if Arbitrage funds can deliver/have consistently delivered these returns in the past.

Category Average Returns
Type of Scheme	1 mth (%)		3 mth (%)		6 mth (%)		1 yr (%)
	Pre-tax	Post-tax	Pre-tax	Post-tax	Pre-tax	Post-tax	Pre-tax	Post-tax
Arbitrage	7.2	6.12	6.8	5.78	7.4	6.29	7.5	7.5
Liquid	7.2	5.04	7.2	5.04	7	4.9	7.4	6.66
Ultra Short Term	6	4.2	8	5.6	8.4	5.88	8.5	7.65
Short Term	3.6	2.52	8.8	6.16	8.8	6.16	9.1	8.19
Fixed Deposits (SBI)	6.50	4.55	6.50	4.55	6.50	4.55	8.75	7.88

Data from- moneycontrol.com & sbi.co.in

The recommended holding period for Arbitrage schemes is 3 months. The past-returns of the schemes we currently recommend in the category are as follows:

Scheme Name	3 month return	6 month return	1 yr return
Kotak Equity Arbitrage	8	9.1	8.9
SBI Arbitrage Opportunities Fund	7.6	8.9	8.3
IDFC Arbitrage Fund	7.6	8.5	8.4

A ready reckoner for Tax laws related to Mutual Funds is available here.

The income tax rules regarding Capital gains is available here.  

For articles related to Arbitrage funds please read-

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