Introduction

Striking the right balance between stability and opting for a way where you see your money grow beyond the traditional low-risk options, is what many investors are trying to master. This can be particularly challenging with the market ups and downs. 

Needless to say, it never hurts to learn more about other options and find out which path suits your needs. In that way, we will explore arbitrage funds. 

While overnight and liquid funds offer stability, their returns might not always excite you. This is where arbitrage funds come into play. 

These are fascinating hybrid schemes designed to exploit small pricing inefficiencies between different market segments, predominantly the cash and futures markets, to generate low-risk returns. 

The rising popularity of arbitrage funds isn't surprising, as more and more investors are seeking that sweet spot of stability combined with better returns than traditional ultra-safe options.

Indus NZ offers an easy way for NRIs to invest in India. Learn more about how Indus work and how you can get started with Indus NZ in under 3 minutes. 

How Arbitrage Funds Work

So, how exactly do these funds operate? It’s all about spotting and capitalizing on tiny price differences for the same asset in two different markets. 

Think of it like this: a stock might be trading at ₹100 in the cash (spot) market, but its corresponding future contract might be at ₹102. 

For arbitrage funds, the manager would simultaneously buy the stock in the cash market and sell its future contract. As the expiry date of the futures contract approaches, the prices in both markets tend to converge. 

This convergence allows the fund to capture that small ₹2 difference as profit, regardless of whether the stock price goes up or down. This strategy is known as "cash and carry" arbitrage.

It’s crucial to understand that these deals rely on precise, simultaneous execution to lock in the profit and minimize risk. 

Because these price differences are often fleeting and small, fund managers execute a high volume of trades. 

What happens if there aren't enough attractive arbitrage opportunities? In such scenarios, the fund manager will typically shift a portion of the fund's assets into debt or money market instruments. 

This ensures that the capital continues to earn some return while awaiting new opportunities.

A key point to note, as per SEBI (Securities and Exchange Board of India) guidelines, is that at least 65% of an arbitrage fund's assets must be invested in equity or equity derivatives. 

This specific allocation is important because it dictates how these funds are classified for tax purposes, which we’ll delve into next.

Tax Treatment of Arbitrage Funds

Despite being hybrid schemes that blend elements of both equity and debt, the SEBI guideline requiring at least 65% equity or equity derivatives investment means that arbitrage funds are taxed as equity funds. This is a significant advantage for investors.

Let's break down the tax implications:

Short-Term Capital Gains (STCG) 

If you redeem your units within 12 months of purchase, the gains are considered short-term and are taxed at a flat rate of 20% (plus applicable surcharge and cess).

Long-Term Capital Gains (LTCG) 

If you hold your investment for more than 12 months, the gains are classified as long-term. For LTCG from equity-oriented funds, gains up to ₹1 lakh in a financial year are exempt from tax. 

Any gains above ₹1 lakh are taxed at 12.5% (plus applicable surcharge and cess) without indexation benefits.

Now, let’s compare this with debt funds. Debt funds are taxed differently:

• Capital Gains

Gains from investments are added to your income and taxed according to your individual income tax slab. The period where you hold your investment is not a factor when it comes to debt funds unlike that of equity funds. 

This could mean a tax rate as high as 30% or more for high-income earners. Therefore, the tax efficiency of arbitrage funds can be a big draw.

Risk vs. Return: Arbitrage vs. Equity vs. Debt Funds

When evaluating any investment, understanding its risk and return profile is essential. Arbitrage funds offer a unique blend, positioning them somewhere between traditional equity and debt funds.

Risk Profile

Arbitrage funds are generally considered to have a risk profile close to that of debt funds. This is because their core strategy involves hedged equity exposure, meaning the buying and selling positions largely cancel out market price fluctuations. 

When arbitrage opportunities are scarce, as a common practice, the funds typically park money in stable debt and money market instruments, further contributing to their lower risk. 

While they aren't entirely risk-free, many investors know that they certainly carry significantly less market risk compared to pure equity funds.

Returns: Here’s a general comparison of typical mutual fund returns:

Equity Funds

These aim for higher growth and can yield significantly more, often in the range of 12%–15% or even higher over the long term. However, this comes with much higher volatility during market downturns.

Arbitrage Funds

Investors generally expect returns in the range of 6%–8% annually. These returns of arbitrage funds are more consistent and less volatile than equity funds, making them a suitable option for those who prioritize stability.

Debt Funds 

These typically offer returns in the 5%–7% range, with lower volatility than equity funds. They are often chosen for capital preservation and stable, albeit modest, income.

Let's look at a quick comparison table to highlight the key differences:

Potential Downsides of Arbitrage Funds

While arbitrage funds offer an attractive proposition, it’s important to be aware of their potential drawbacks before investing.

1) Returns may drop in low-volatility phases 

The very nature of arbitrage funds relies on market inefficiencies and price differences. In periods of low market volatility, these opportunities become scarce. 

Consequently, the fund managers might have to park a larger portion of the corpus in debt instruments, leading to returns that might closely mimic those of liquid or ultra-short-term debt funds. 

So, investors expecting consistent high returns usually remember that market conditions play a role.

2) Higher expense ratios due to frequent trading 

Arbitrage strategies involve frequent buying and selling of securities to capture small price discrepancies. 

This active management and high turnover can result in higher expense ratios compared to passively managed funds or even some debt funds. 

Higher expense ratio means a larger portion of your potential gains goes towards fund management fees, effectively eroding your net returns. It's something investors consider when comparing funds.

3) Execution risks 

Despite the hedged nature, there are always minor execution risks. Markets can move incredibly fast. 

Even a slight delay in executing simultaneous buy and sell orders, or issues with settlement lags, could potentially reduce or even negate the intended arbitrage profit for that specific trade. 

While fund managers are highly skilled, it's a factor inherent to the strategy.

How Investors Compare Arbitrage Funds before Investing

Choosing arbitrage funds involves more than just looking at past returns. Here's what investors typically consider:

1) Monitor rolling returns over 1-year horizons 

Instead of just looking at point-to-point returns, investors look at rolling returns to provide a more comprehensive picture of a fund's consistent performance over various periods. 

For arbitrage funds, checking 1-year rolling returns can give you a good sense of how consistently they've managed to generate returns in different market cycles.

2) Watch expense ratios 

As mentioned earlier, expense ratios can significantly impact your net returns. 

Funds with an expense ratio greater than, say, 1.2% (this is a general guideline, actual good expense ratios for arbitrage funds can be lower, often in the range of 0.3-0.5% for direct plans as per recent data) could eat into your gains. 

Investors often consider direct plans if possible, as they typically have lower expense ratios.

3) Review fund size (AUM), liquidity, and manager track record:

• Assets Under Management (AUM): A larger AUM can sometimes indicate the fund's popularity and investor confidence, but it can also present challenges in efficiently deploying capital into small arbitrage opportunities.

• Liquidity: Investors typically look for funds with good liquidity to ensure they can redeem their investment when needed without issues.

• Manager Track Record: A seasoned fund manager with a proven track record in navigating various market conditions and consistently identifying arbitrage opportunities is a strong positive sign.

4) Compare post-tax expected yields vs. liquid funds or ultra-short debt funds 

This is especially crucial for high-tax bracket individuals or Non-Resident Indians (NRIs). 

Given the tax efficiency of arbitrage funds (taxed as equity), their post-tax returns can often be significantly better than liquid or ultra-short debt funds, even if their pre-tax returns appear similar. 

It's often beneficial for investors to do a post-tax comparison to truly understand the net benefit.

Using Indus NZ to Explore Mutual Funds

For New Zealand residents looking to explore investment opportunities in India, especially in mutual funds, platforms like Indus NZ offer a streamlined experience. 

While Indus NZ currently doesn't offer arbitrage funds (as of now), it provides easy access to a wide array of over 500 mutual funds in India. 

One of the standout features of Indus NZ is our commitment to low foreign exchange (FX) rates. Our 1% lowest FX rate ensures that you get more INR for every NZD you convert, maximizing your investment power. 

The process is designed to be incredibly smooth, with KYC approval often completed in as little as 3 minutes. We also help navigating the Double Taxation Avoidance Agreement between NZ and India.

Furthermore, you don't even need an NRE account in India to start investing through Indus NZ, making it incredibly convenient for NRIs from New Zealand. 

Remember, while the focus is currently on mutual funds, we are looking to introduce direct investment soon.

Conclusion

In summary, arbitrage funds present a compelling investment option for those who desire a balance between lower risk and decent, tax-efficient returns. 

They skillfully leverage market inefficiencies, offering a distinct advantage over traditional savings instruments and even some debt funds, especially when considering post-tax yields.

These funds are particularly considered by investors in higher tax brackets or those looking for stable short-to-medium-term returns without the significant volatility associated with pure equity investments. 

As with any financial decision, it's wise to compare thoroughly with other debt and equity options, always considering your personal risk tolerance, expected yield, and tax implications. 

When you're ready to make your choice, Indus NZ can be incredibly helpful for quick comparisons and painless onboarding. We ensure you can start building your Indian mutual fund portfolio with ease, even if arbitrage funds aren't currently on our menu.

FAQs on Arbitrage Funds

1. What is the primary goal of an arbitrage fund? 

The main goal of an arbitrage fund is to generate low-risk returns by exploiting temporary price differences of the same asset in different market segments, typically the cash and futures markets.

2. Are arbitrage funds suitable for long-term investment? 

Arbitrage funds are generally better suited for short to medium-term investment horizons (typically 3 months to 2 years) due to their strategy relying on transient market inefficiencies.

3. How is the risk in arbitrage funds managed? 

Risk in arbitrage funds is managed by simultaneously buying and selling the same asset, creating a hedged position that largely neutralizes market price movement risk.

4. What happens if there are no arbitrage opportunities? 

If arbitrage opportunities are scarce, fund managers typically invest the fund's capital in debt and money market instruments to ensure continued, albeit lower, returns.

5. Why are arbitrage funds considered tax-efficient for higher tax brackets? 

Arbitrage funds are taxed as equity funds, meaning long-term capital gains above ₹1 lakh are taxed at a lower rate of 10%, which is often more favorable than debt fund taxation for high-income earners.

Standard Disclaimer

Investing involves risk, and returns are not guaranteed. Please conduct your own research before making any investment decisions. This information is provided for general purposes only and does not constitute financial advice.

Indus does not provide investment, financial, legal, or tax advice. While we facilitate access to Indian mutual funds, any decision to invest is solely your responsibility. You should consult a qualified financial adviser or tax specialist before making any investment or tax-related decisions, especially if you are uncertain about how these investments apply.