The fund predominantly invests in cash and future markets (equity) with some allocation in fixed income instruments spreading across fixed deposits and balance in cash & short-term debt instruments. On an average the fund would usually allocate 65% + in arbitrage (65-75%), 10% -25% in Fixed deposits (for margin money for derivative trades) and 0-10% in debt and money market instruments (mainly TREPS).

Arbitrage is simultaneous buying and selling the same underlying security or its derivatives in different market segments to make risk free profits.

Most commonly arbitrage fund uses cash and carry arbitrage (price differential between cash and future market). The Index and basket of stocks arbitrage (price differential between Index and basket of stocks constituting Index), exchange arbitrage (price differential among two exchanges) are rarely used.

Sometimes arbitrage funds also takes advantage of price differential created by corporate events such as Merger and Acquisitions (M&A), Buy backs, Rights issue etc. However, these opportunities are very rare. Also, they need to be executed properly to ensure that the trades are rightly executed.

Price of the same security is different in two stock exchanges e.g. share of a company is trading at Rs 100 in NSE and Rs 101 in BSE. You can lock-in Rs 1 profit / share by simultaneously buying it in NSE and selling it in BSE.

Cash and carry arbitrage is the most common arbitrage strategy used by arbitrage mutual funds. This strategy takes simultaneously position in one stock in cash and future market. The fund buys in cash market and sells in future markets The primary objective of this is to lock in spread available between these two markets.

For Example : Price of the share of a company in the cash market is Rs 1785 and price of the current series future of the same company in the Futures and Options (F&O) market is Rs 1794. You can lock-in Rs 9 profit / share by simultaneously buying the share in cash market and selling it in the future market.

This is essentially same as cash and carry arbitrage ‒ the only difference is that instead of a single stock here the arbitrage is for the index.

For example, Nifty is trading at Rs 9,300 in the F&O market whereas equivalent price of a basket of stocks constituting Nifty (in the same proportion as the index) is Rs 9275 in the cash market. You can lock-in Rs 25 profit per Nifty future contract by simultaneously selling Nifty and buying the basket of stocks in the cash market.

Arbitrage funds are relatively safe, and carry little risk. The risk of equities is reduced by hedging against the derivatives. However, there are certain inherent risk attached to arbitrage strategies and factors like lack of arbitrage opportunities, their perfect execution and the liquidity in the stock/cash and futures segments are some of the factors that can contribute to the uncertainty & risk.

If you invest in low rated debt instruments, there are some risks like default risk and rating downgrade risks.

Yes, arbitrage fund returns at times can be volatile or post a negative return on a single day due to mark to market losses. This mark to mark (MTM) loss can happen in both in equity and debt portion.

The marked to market valuation of equity portion of the portfolio happens daily till the expiry date. This valuation is benchmarked against the locked in yield / rollover yield of the portfolio which in turn decides the return for the day. So even if market has gone up / gone down on a single day, the portfolio movement can be opposite till the existing positions are closed and new rollover yield is locked into. from the previous level of locked in yield of the portfolio.

There can be volatility or negative returns due to debt portions as well because of MTM and higher duration paper.

The above scenarios can drive arbitrage fund to post a negative return. However, one single day return can be outlier and may not be worthwhile to measure fund’s consistency over a period time.

Tax advantage is a great plus for arbitrage funds. When the equity holdings in the cash market are held over and above 65%, these schemes are considered as equity funds. The equity orientation of the fund gives an edge over debt and liquid investment options. .

While profits made in debt funds held for less than 36 months is taxed as per the income tax rate of the investors, profits made in arbitrage funds held for less than 12 months (short term capital gains) is taxed at 15% plus applicable surcharge and cess. If units of arbitrage funds are sold after 12 months from date of purchase then profits (long term capital gains) of up to Rs 1 lakh are tax exempt in a financial year. Long term capital gains in excess of Rs 1 lakh are taxed at 10% only.

For Instance

Short Term capital gain Taxation

Long Term capital gain Taxation#

Note: This is only for illustration purpose. Surcharge, if applicable, considering the category and income of the investor may also be payable. * Tax rates assumed for individuals/HUFs are for highest Tax bracket as on 31st May, 2020.The rate for resident individuals & HUFs is 20.80 % including cess for long term capital gains. STT is also payable over and above capital gains tax, as per applicable rates for Equity Oriented Funds Rates mentioned may be subject to MAT also. Please consult your financial and tax advisor and read and understand the concerned Scheme Information Document and the SAI before arriving at any investment decision. #Long term period for other than Equity Fund is more than 36 months.

The margin money is required for taking arbitrage position (i.e. future positions) in the market. Generally, it is kept in the form of short-term deposits, cash or cash equivalents as per the regulations. Fund have to maintain enough balance to maintain that account on daily basis. At the end of each trading day, the margin account is adjusted to reflect gain or loss depending upon the future closing price.

An investor should check from SID that fund mandate is to run 100% fully hedged equity portfolio and quality of fixed income portfolio in terms of Credit and Duration risk.