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Arbitrage funds have been drawing a huge number of investors this year.  Just July, 2023 saw Rs 10,074.87 crores worth of inflows here. As per AMFI, the average asset under management (AUM) of all 26 active schemes of these funds, grew from Rs 87,315.98 crores in March, 2023 to Rs 99,966. 28 crores in July, 2023. But why are these funds currently in vogue? We decode. 

How arbitrage works

The word arbitrage means to buy something from place A, and sell the same thing at place B, at a higher price. So, arbitrage funds utilize the price difference present in the cash (spot) market, and derivatives market. This price difference is inherent in the way these markets work. Let’s understand this. 

In a cash/spot market, the real-time value of an asset is taken for a transaction. So, if shares of company B are trading at Rs 50/share in the cash market, Aman will have to pay Rs 50 each for buying 50 shares. This way, Aman will spend Rs 2,500 to get these shares. 

But the derivatives market, however, works differently. Here, the price of company B’s shares will not be transacted at their real-time value i.e. Rs 50. Instead, they will be traded in the future, at a price and date already determined by the buyer and seller today. The price will be fixed on a speculative basis, i.e. whether the price of these shares will rise or fall during the said time. 

Say Anand speculates that the prices of B’s shares will rise to Rs 70/share in the future. He buys 50 shares for Rs 50 each in the spot market, and sells these 50 shares for Rs 70 each in the derivatives market. This way, he rakes in a profit of Rs 3,500, while making a net profit of Rs 1,000 (3,500-2,500) in the entire process. This is what arbitrage is.  

Arbitrage mutual funds make the best of the volatility in two different markets, which gives birth to the price difference of the same security in both markets. This is why they are generally considered low risk. 

However, as SEBI-registered RIA Jay Thacker puts it, “Arbitrage funds are not that suitable for regular retail investors to achieve their goals. The kind of returns generated by arbitrage funds can be achieved with more certainty in other simpler hybrid fund options. The structure and strategy of arbitrage funds is such that it requires patience and high capital investment to generate suitable returns over market cycles”. 

On an average, hybrid arbitrage funds have delivered 6.32% returns over a 1-year period, and around 1.74% in a 3-month time. Here’s how some major arbitrage funds have performed recently.

As is evident, most arbitrage funds deliver anywhere between 7.3% to 7.8% over a year. Over 6 months, the returns are consistently over 3.8%. For instance, Invesco arbitrage fund delivers 3.99% returns in a 6-month time frame. 

Favourable taxation a big draw 

A major benefit that these funds offer, says financial planner Shifalee Satsangee, is that they are taxed like equity, and hence, are far more lucrative than debt funds. 

Here’s the difference. Your gains in debt funds, which you have held for less than 3 years or 36 months i.e. for short-term, will be taxed on the basis of your applicable tax rate. But that’s not the case with arbitrage, despite generating returns akin to debt funds in the short run. . 

But for arbitrage funds, the short term is reduced to 12 months. So, if you’ve earned profits from arbitrage funds held for less than 12 months, that will be subject to short-term capital gains tax (STCG), which will be levied at 15%+ surcharges and cess. 

Moreover, if you sell your arbitrage fund units after 12 months, all profits earned up to Rs 1,00,000 are exempt from taxes. Gains above Rs 1 lakh are taxed at 10%.