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Baffled by Arbitrage Funds? Here's the simple explanation.

Pursuant to my post 'Arbitrage funds : Excellent way to park short-term money', I have received some queries. It seems people are somewhat confused about the nature and risk in such funds. This, particularly when I advised that you must choose funds with more than 65% exposure to equity / derivatives and preferably redeem it on the last Thu of the month.

So I guess an introductory write-up on the Arbitrage Funds is called for.

Arbitrage funds are a special type of fund that aim to take advantage of the difference in the share prices in the ‘cash’ and ‘derivatives’ market.

Suppose on Jan 1, I "buy" TCS @ Rs.2000/share in the cash market. Simultaneously, I will "sell" TCS in the futures market, which would be quoting for say about Rs.2020.

Now, two scenarios are possible on the day when the futures contract expires. This is fixed as last Thu of the month.

Scenario 1: Suppose the TCS price rises to Rs.2200.
Thus, I make Rs.200 profit in the cash market [= Rs.2200 – Rs.2000]. But, I lose Rs.180 in the futures market [= Rs.2020 - Rs.2000]. Thus, I make an overall profit of Rs.20.
IMP: On the expiry date, the cash and future prices converge and are the same. (And hence my strong recommendation that these funds should ideally be redeemed on the last Thu of the month).

Scenario 2: Suppose the TCS price crashes to Rs.1500.
Now, I lose Rs.500 in the cash market [= Rs.1500 – Rs.2000] and make a profit of Rs.520 [Rs.2020 – Rs.1500] in the futures market. Again, my overall gain is Rs.20.

Hence, by taking "equal and opposite" position in two different markets, I earn assured and fixed return of 10% [= Rs.20 / 2000], irrespective of the market movement. [For simplicity, I have ignored the premium that I receive when I sell futures.] 

This is exactly what the arbitrage funds do. This is how they deliver steady and stable returns, which is more or less in line with the interest rates prevailing in the market. Instead of aiming to make money on equity or derivatives, they aim to benefit from differential pricing.

Since they deliver assured, fixed and stable returns, they are as good as FDs.

Since they are not affected by market movements, they are as safe as FDs.

But why the 65% exposure benchmark?
The answer... our tax laws. If the total exposure of any fund to equity / derivatives exceeds 65%, they are classified as equity funds, wherein Short Term Capital Gains (STCG) Tax is 15% and Long Term Capital Gains (LTCG) Tax is Nil. This allows arbitrage funds to deliver “tax-efficient" returns. 

If this exposure is below 65%, they get classified as debt funds, wherein STCG is taxed as per investor's slab rate while LTCG attracts 10%/20% tax (without / with indexation).

By the way, there is a minor risk with these funds. Rest assured, it is nothing serious. There may be occasions when such price differentials are not available or very small. So the fund manager would have to invest part of the corpus in the standard debt instruments. And if this exposure to debt increases beyond 35%, the tax rates of debt funds will apply. These may marginally reduce the yields. However, despite this your net returns will rarely fall below what you would have otherwise made in the FDs. (Hence my suggestion to look for smaller funds.)

Concluding, therefore, arbitrage funds are a good alternative to bank FDs, where one can earn high post-tax returns – with a high degree of safety and surety.

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