Arbitrage Funds – What Are They?
“I want to invest safely and tax-free, and get a higher return than FD”.
In search of this “ultimate” investment, one strategy used by investors is arbitrage trading.
Understanding arbitrage
Simply put, you buy a stock on the spot market and book an advance sale of that stock on the futures market quoted at a higher price. By pre-locking prices, returns are also locked.
Essentially, this is what arbitrage funds do.
Arbitrage funds use stocks and commodities as underlying investments to take advantage of price differences between the spot and futures markets. In the process, this limits the upside return, as the selling price is pre-determined.
That’s a good idea. maybe not.
Let’s understand a little more about arbitrage funds.
First Few Facts About Arbitrage Funds
oneA typical portfolio of an arbitrage fund consists of stocks, futures contracts, debt and money market investments. They are hybrid in nature as they invest in combinations of investments.
two, the benchmark for most arbitrage funds is the Liquid Fund Index. What that means is that they are meant to match the returns of liquid or ultra-short term debt funds.
you ask – “Why would a fund that invests primarily in equities and equity-related investments generate debt investment returns?”
Worse yet, why risk a stock investment and still get a liability like return? The following facts will answer your question.
three, the tax treatment of arbitrage funds is like stocks. After holding for one year, you do not have to pay long-term capital gains tax. Short-term profits of less than one year are only taxed at 15%.
This is the biggest reason to invest in arbitrage funds. Earn a debt-like income, but tax-free after a year. For people in the highest tax brackets, this is a great incentive.
Unsurprisingly, many investors are pouring money into arbitrage funds, especially in the short term.
question –
- Should you really invest in these funds?
- How big are the tax benefits?
- Can I leave my debt funds alone?
Let’s compare.
Comparison of arbitrage funds, ultra short-term funds and liquid funds
The following table compares some of the popular arbitrage funds with ultra-short-term and liquidity funds.
sauce: Unobest Research; all scheme data are for direct plans as at 30 December 2022. Best and worst performance are for the 12 months the fund has been in existence. All returns are %.
based purely on returnsliquid funds and ultra-short-term funds are superior to arbitrage funds.
even for Best and worst performance in any one yeararbitrage funds are not much better than ultra-liquid short-term funds.
As for what you should go for, it seems like a no-brainer.
wait a minute. what about taxes? Well, it could be a twist.
think about taxes
The tax rates applicable to the short-term profits of debt funds vary from tax rate to tax rate. If you belong to the highest tax rate, pay 30%+.
As you know, from a tax perspective, a debt fund’s profits are treated as short-term if they are sold within three years of purchase.
The short-term arbitrage fund tax rate is only 15% + surcharge. Long term (post 1 year) is 10% + additional charge.
Arbitrage funds clearly have a decisive tax advantage. With low tax rates (especially for those who belong to the highest tax rates), there are compelling reasons.
However, remember that you must invest in an arbitrage fund for at least 6 months in order to benefit from it.
Note: If you’re doing systematic transfers, I’d recommend using liquid funds given that you don’t scream volatility.