Arbitrage funds are low risk mutual fund schemes which aim to exploit pricing mismatches in various segments of equity markets to generate risk free profits for investors. Let us understand arbitrage opportunities with an example.
Suppose the share price of a company is Rs 100 and the futures price (in F&O market) is Rs 110. On the expiry of the futures contract, the spot price (share price in cash market) and futures price will converge. If you buy 1000 shares of the company in the cash market and sell 1000 futures, you will lock in a gross profit of Rs 10,000 irrespective of whether the price rises or falls.
While historical data shows that, arbitrage opportunities exist in Indian equity markets most of the times, volatility in the equity market increases the pricing mismatches between different market segments and hence arbitrage profits are higher in volatile markets. This is one investment product that helps investors profit from economic uncertainties and volatility in the equity markets.
Investors can park their funds which they plan to use for short term requirements in arbitrage mutual funds, instead of keeping them in savings account or even money market mutual funds like liquid funds or ultra-short term funds. Data shows that, in volatile market conditions, arbitrage funds outperform liquid funds. Arbitrage funds have low risk and are highly liquid, which means that you can redeem your fund at any time to use it for your emergency needs. Please note that, arbitrage funds can charge exit loads for redemptions within a week or a month (read the scheme information document of the fund you are investing in carefully before investing).
The tax advantage of arbitrage mutual funds makes it a winner in volatile markets. For taxation purpose arbitrage mutual funds are treated as equity mutual funds. Short term capital gains (holding period of less than a year) are taxed at 15%, while long term capital gains (holding period of more than a year) are tax free. Dividends declared by arbitrage mutual funds are also tax free. Investors have different strategies to deal with uncertainty, but arbitrage mutual funds can always help with cash flows through higher returns in the times of emergency or sudden need of funds.
Please read – What are mutual fund tax benefits