Your Questions Answered: What are arbitrage funds and how are they different from largecap funds?

Q. I am a civil engineer working with a construction company in Pune, my wife is a scientist working with a bio-medical start-up in Pune. We have been invested in largecap and midcap mutual funds for the past 8 years. We now wish to invest in other categories of mutual funds. Markets have been choppy in recent months, and some of my acquaintances have suggested we invest in arbitrage mutual funds given the market conditions. However, we are not familiar with arbitrage funds. Can you please elaborate on what are arbitrage mutual funds, how they are different from largecap mutual funds and what are the pros and cons of investing in arbitrage mutual funds?

Jitesh Karmarkar, Pune, Maharashtra

Introduction

In the ever-evolving landscape of financial investments, arbitrage mutual funds have emerged as a popular choice for investors seeking low-risk returns. These funds leverage price differences in various markets to generate profits, making them an attractive option for those looking to balance risk and reward. Let's delve into the intricacies of arbitrage mutual funds in India and understand why they might be a suitable addition to your investment portfolio.

What are arbitrage mutual funds?

Arbitrage mutual funds are a type of hybrid fund that aims to exploit price differentials between the cash (spot) market and the futures market or the price difference between the price of a security on different stock exchanges. By simultaneously buying and selling securities in these markets, these funds lock in profit in a relatively low-risk manner. The primary objective is to capitalise on the price discrepancies that arise due to market inefficiencies.

How do they work?

The working mechanism of arbitrage mutual funds involves a few key steps:

Market neutral strategy: Arbitrage mutual funds employ a market-neutral strategy, meaning they can generate returns irrespective of market direction. Whether the market is bullish or bearish, these funds can exploit price differentials to generate profits. This makes them ideal for choppy markets where predicting market movements is challenging.

Low risk: One of the primary advantages of arbitrage mutual funds is their low-risk nature. Since the transactions are executed simultaneously in different markets, the risk associated with price fluctuations is minimal. This makes them a safe investment option compared to other equity funds, especially during periods of high volatility.

Stable returns: Arbitrage funds offer relatively stable returns, which are not significantly affected by market volatility. This stability is particularly appealing to investors who prefer predictable outcomes over high-risk, high-reward scenarios. In a choppy market, where prices can swing wildly, the stability of arbitrage funds can provide a sense of security.

Difference between largecap and arbitrage mutual funds

Difference in investment strategy:

Arbitrage mutual funds: These funds capitalise on price differences between the cash and futures markets. The strategy involves simultaneous buying and selling of securities to lock in profits, making them market-neutral.

Largecap mutual funds: These funds invest in largecap companies with strong market positions. The strategy focuses on long-term growth and capital appreciation by investing in well-established companies.

Difference in risk profile:

Arbitrage mutual funds: They are considered relatively low-risk investments due to their market-neutral strategy. The simultaneous transactions minimise the impact of market volatility.

Largecap mutual funds: While they are less risky compared to mid-cap and small-cap funds, they still carry market risk. The performance of largecap funds is influenced by the overall market conditions and the performance of the underlying companies.

Difference in returns:

Arbitrage mutual funds: These funds offer relatively stable returns, which are not significantly affected by market volatility. However, the return potential is generally lower compared to equity funds.

Largecap mutual funds: These funds have the potential for higher returns due to their investment in large, financially stable companies. The returns are linked to the performance of the stock market and the growth of the invested companies.

Difference in liquidity:

Arbitrage mutual funds: These funds are highly liquid, allowing investors to redeem their investments easily without significant delays or penalties.

Largecap mutual funds: These funds are also liquid, but the liquidity can be influenced by market conditions and the performance of the underlying stocks.

Difference in investment horizon:

Arbitrage mutual funds: Suitable for short to medium-term investment horizons, making them ideal for parking surplus funds.

Largecap mutual funds: Best suited for long-term investment horizons (5 years or more) to benefit from the growth potential of largecap companies.

Pros of investing in arbitrage mutual funds

Relatively low risk: One of the primary advantages of arbitrage mutual funds is their low-risk nature. Since the transactions are executed simultaneously in different markets, the risk associated with price fluctuations is minimal. This makes them a safe investment option compared to other equity funds.

Stable returns: Arbitrage funds offer relatively stable returns, which are not significantly affected by market volatility. This stability is particularly appealing to investors who prefer predictable outcomes over high-risk, high-reward scenarios.

Liquidity: These funds are highly liquid, allowing investors to redeem their investments easily. This liquidity ensures that investors can access their funds when needed without significant delays or penalties.

Diversification: Arbitrage mutual funds provide diversification benefits by investing in a mix of equity and derivative instruments. This diversification helps in spreading risk and enhancing the overall stability of the investment portfolio.

Market-neutral strategy: The market-neutral strategy employed by arbitrage funds ensures that they can generate returns irrespective of market direction. Whether the market is bullish or bearish, these funds can exploit price differentials to generate profits.

Professional management: Arbitrage mutual funds are managed by professional fund managers who have the expertise to identify and capitalise on arbitrage opportunities. This professional management adds an extra layer of security and confidence for investors.

Cons of investing in arbitrage mutual funds

When it comes to sector-specific funds, such as those focusing on banking and financial services, investors should be aware of the unique set of challenges they may face such as the ones enumerated below:

Limited returns: One of the primary disadvantages of arbitrage mutual funds is their limited return potential. Since these funds primarily exploit price differences between the cash and futures markets, the returns are generally lower compared to pure equity funds especially over the long term. Investors seeking high returns over the long term may find arbitrage funds less appealing.

Market dependency: Although arbitrage funds are designed to be market-neutral, their performance can still be affected by market conditions. During periods of low volatility, the opportunities for arbitrage may be limited, resulting in lower returns. Conversely, in highly volatile markets, the risk of mispricing can increase, potentially impacting the fund's performance.

Tax implications: While arbitrage funds are taxed as equity funds, which can be beneficial, there are still tax implications to consider. Short-term capital gains (STCG) are taxed at 15%, which can be a significant amount.

Complexity: Arbitrage mutual funds involve complex trading strategies that may not be easily understood by all investors. The simultaneous buying and selling of securities in different markets require a high level of expertise and understanding of market dynamics. This complexity can be a deterrent for novice investors who prefer simpler investment options.

Costs and fees: Arbitrage funds often come with higher costs and fees compared to other mutual funds. The frequent trading required to exploit arbitrage opportunities can lead to higher transaction costs. Additionally, the management fees for these funds can be higher due to the specialised skills required to manage them effectively.

Liquidity risk: While arbitrage funds are generally considered liquid, there can be instances where liquidity becomes an issue. During periods of market stress or low trading volumes, it may be challenging to execute trades at desired prices, potentially impacting the fund's performance.

Arbitrage mutual funds offer a unique investment opportunity with several benefits, but they also come with their share of drawbacks. Limited returns, market dependency, tax implications, complexity, costs, liquidity risk, and limited growth potential are some of the cons that investors should consider. By understanding these potential downsides, investors can make informed decisions and choose the investment options that best align with their financial goals and risk tolerance.

Who should invest in them?

Arbitrage mutual funds are ideal for:

Short to medium-term investors: If you have a short to medium-term investment horizon (3-6 months), arbitrage mutual funds can be a suitable option for parking your surplus funds. They offer liquidity and relatively stable returns, making them ideal for short-term financial goals.

Investors seeking diversification: Arbitrage mutual funds provide diversification benefits by investing in a mix of equity and derivative instruments. This diversification helps in spreading risk and enhancing the overall stability of your investment portfolio.

Performance and returns

Several mutual funds houses in India have launched arbitrage mutual funds in India, especially in the recent past. This allows investors to diversify their portfolio by investing in a class of mutual funds following a unique investment strategy. Here are the top 5 arbitrage mutual funds (direct schemes) ranked based on their 3-year performance.

Source: AMFI website. All data as of 14 November 2024.

Note: Past performance is not an indication of future returns.

How are they taxed?

Before the Budget 2024, arbitrage mutual funds were taxed as equity funds, this meant that:

Short-Term Capital Gains (STCG): Gains from investments held for less than a year were taxed at 15%.

Long-Term Capital Gains (LTCG): Gains from investments held for more than a year were taxed at 10% for gains exceeding ₹1 lakh.

Changes introduced in 2024

The Union Budget 2024 has brought several changes to the taxation of mutual funds, including arbitrage funds. Here are the key changes:

Increased STCG tax rate: The short-term capital gains tax rate on arbitrage funds has been increased from 15% to 20%. This change means that investors will now face a higher tax burden on gains from investments held for less than a year.

Revised LTCG tax rate: The long-term capital gains tax rate has been raised to 12.5%. This change affects gains from investments held for more than a year, reducing the tax efficiency of arbitrage funds.

Rationalized holding periods: The holding periods for short-term and long-term capital gains have been rationalised to 12 and 24 months, respectively. This means that all listed securities will be classified as long-term if held for over 12 months, while other asset classes will be classified as long-term if held for more than 24 months.

The changes introduced in Budget 2024 have several implications for investors in arbitrage mutual funds:

Higher tax burden: The increase in STCG tax rate to 20% means that investors will now have to pay more tax on gains from short-term investments. This reduces the net returns from arbitrage funds, making them less attractive for short-term parking of funds.

Reduced tax efficiency: The revised LTCG tax rate of 12.5% also impacts the tax efficiency of arbitrage funds. While the long-term gains are still taxed at a lower rate compared to short-term gains, the increase in tax rate reduces the overall tax advantage.

Conclusion

Arbitrage mutual funds offer a compelling combination of low risk, stable returns, and tax efficiency, making them an attractive option for a wide range of investors. By understanding your investment goals and risk tolerance, you can determine if arbitrage mutual funds are the right fit for your portfolio. 

Kuvera is a free direct mutual fund investing platform. Unless otherwise stated data sourced from BSE, NSE and kuvera.