What is Arbitrage Mutual Funds?

by Mr. Brijesh Damodaran, Zeus WealthWays LLP

The last few weeks have seen a new buzz in the mutual fund (MF) space, with fund houses promoting arbitrage funds & investors lapping it up. These funds have always been in the investment basket, but never at the forefront as an investment option.

Over the past 3 months, many fund houses have come out with NFOs (New Fund Offers) of these funds; besides, existing arbitrage funds are seeing fresh inflows.

What is arbitrage fund ..

An arbitrage fund is an open-ended equity scheme that aims to generate capital appreciation and income by predominantly investing in arbitrage opportunities in the cash and derivatives segment of the equity market and investing the balance, if any, in debt and money market instruments.

The fund exploits arbitrage opportunities by buying stocks in the spot market and selling corresponding futures in matching positions, thereby capturing the positive spread between the prices.

If, during a month, the futures price is more than the cash price, there is a clear arbitrage opportunity. The fund manager in this case buys the stock and shorts its future. This generates a premium, which is a risk-free return.

For instance, say, on July 27, 2014 you buy stock A on the cash market and at the same time sell the futures of Stock A on August 30, 2014 which has a price of Rs. 101. For the arbitrage to work, both transactions happen at the same time and you make a low-risk return.

Why the clamour..

This year's budget brought to attention the advantage of investing in equity arbitrage funds. The long-term holding period of debt mutual funds has been increased from 12 to 36 months, with capital gains tax at 20 % with indexation.

Earlier, it was 12 months with capital gains tax at 20 % with indexation, or / 10 %. With the holding period going up, the tax arbitrage opportunity with other fixed income investment options, like bank fixed deposits, has come down.

This is especially true of investments maturing in one year, or if lumpsum redemptions from an open-ended scheme of a debt MF is considered.

In equity arbitrage funds, the fund manager exploits the differences in prices in the cash and futures market. This enables the fund houses to declare regular dividends, which are tax-free in the hands of the investor.

Fund houses have used this effectively to garner assets under management and to declare regular monthly / quarterly dividends.

Over 3 to 36 months, the existing schemes have generated annualised returns of over 9 %. And these returns are tax-free, if considered at the dividend payout option.

When you gross up the returns pre-tax, you are looking at returns in excess of 13 % (for those in the 30 % tax bracket).

Other alternatives, such as bank fixed deposits (FDs), where interest rates vary between 9 % and 10 %, the post-tax return works out to be about 6% for individuals in the highest tax bracket.

What now..

After the budget, fund houses started pitching arbitrage funds to investors. But, going forward, will arbitrage funds continue to generate the kind of returns they did in the past?

Most of the investments in this case are being issued in the form of bonus units, wherein if the scheme declares a bonus, the capital loss on original units can be carried forward for the next eight years or adjusted against any short-term capital gains in the current year.

So, if past returns are any indicator of the investment strength of arbitrage funds, one can look at allocating some money in these funds.

About the author..

The writer Mr. Brijesh Damodaran is founder & managing partner, Zeus WealthWays LLP

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