Concept Clarifier: Arbitrage Funds
What are arbitrage funds
Arbitrage is the process of buying stocks or shares in one market and selling it in another to exploit the price difference. An Arbitrage fund is a type of hybrid fund which aims to capitalise on proﬁtable arbitrage opportunities (price differential in a stock) between cash and derivatives segments of the equity market. Thus opportunity lies in generating a good return between these differences.
So how do arbitrage funds work?
These funds will initiate an arbitrage position by buying a stock in the cash segment and selling simultaneously equal quantities of the stock in the futures segment of the market. The positions thus initiated are to be reversed before or during the expiry of the futures series.
(The above example shows an illustration of the arbitrage opportunity. It is assumed that the cash and futures prices will converge on the day of the expiry. The above opportunity may or may not be always available in the market. No assurance can be given that prices of stock and stock futures will correlate perfectly on expiry date of stock futures)
What are the key features of arbitrage funds?
• Endeavor to generate positive returns during market volatility
• Tax-efficient, as tax treatment is similar to equity funds
• Aims to Offer relatively risk-free returns among equity investments
• Aims to generate returns through fully hedged exposure to equities
How is arbitrage funds taxed?*
Arbitrage funds hold a minimum of 65% in equities where the same is hedged, thus they are taxed as equity oriented funds. If an investor redeems investments after one year, the gains from overall equities are tax-free up to Rs 1 lakh, as per current tax laws. Beyond this limit, the investor has to pay 10% long term capital gains tax. The short-term capital gains tax is also lower than other debt funds at 15%.
Who are arbitrage funds best suited for?
• Investors who look for low-risk but reasonable returns in a volatile market can consider arbitrage funds as a viable option
• Investors, especially those in the higher income tax bracket, can use them to park money for short period
• Investor with an investment horizon of more than 3 months can park a portion of their portfolio to arbitrage fundss
Further, investors are always advisable to consult their financial and tax advisors to understand the suitability of the product and different options available, before making investments.
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*Tax benefits mentioned are as per the current tax laws and shall be subject to change.
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