What are arbitrage funds? Can they give negative returns? How are they taxed?
Arbitrage schemes are hybrid funds that take arbitrage positions in equity and equity-related instruments for at least 65% of the portfolio. The remaining corpus is mostly in high-quality fixed-income instruments, cash & equivalents.
So How Does It Work?
Arbitrage funds aim to capture the price differential between the spot and futures markets, to generate returns at stock exchanges.
These mutual funds buy securities in the spot market and simultaneously sell them in the futures market. They buy the stock in the lower-priced spot market and sell it in the higher-priced futures market.
The spread differential in the market typically reflects the rates in the money-market rates. This spread differential rises in times of high volatility in the markets, which presents an opportunity for investors to capitalize on the higher rates (relative to money market rates) prevalent in the markets.
These funds cannot engage in reverse-arbitrage, i.e. sell shares and buy futures.
There could be instances where the spreads may turn negative, i.e. the futures price may be at a discount to spot price owing to extreme bearishness in the markets.
The spot and futures positions are marked to market daily, which may result in negative returns before the expiry of the future’s contract. At the expiry of the futures contract, the positions are reversed, and profits are booked based on the price differential at the time of entering the arbitrage position.
Investors with a horizon of over 3 to 6 months, can look to enter such funds, particularly during volatile periods. These funds generally have an exit load of 3 to 6 months. On a pre-tax basis, the returns of these funds are close to that of liquid funds. However, arbitrage funds have favorable taxation, which yields higher post-tax returns for the same level of pre-tax returns.
For holding periods of up to 1 year, short-term capital gains are taxed at 15% (excluding cess and surcharge, if applicable), as compared to the 30% tax rate for liquid (and other debt funds) for investors in the highest tax bracket.
For holding periods of 1 to 3 years, gains in arbitrage funds are taxed at only 10% (only excess gains above Rs 1 lakh are taxed), compared to 30% for the highest tax bracket investor.
Arbitrage funds subject investors to lower credit risk than liquid funds, as more than 65% of the portfolio is invested in arbitrage opportunities.
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