Equity funds are highly volatile and very risky for a brief-term, debt funds are somewhat sidelined by return-conscious investors looking to park money for a brief duration. Investors with a higher risk appetite can explore arbitrage funds to park short-term funds. Arbitrage funds are like liquid funds within the debt offerings in terms of their risk-return outcomes. So, while they will be considered for very short investment horizons, they’re generally not suitable for a steady-state fixed-income allocation. This is often because the returns from them might not be adequate.
On a pre-tax note, arbitrage funds reward slightly lower returns than liquid funds over any fix of 1-year. But because of their preferable tax treatment, they pip liquid funds on a post-tax basis for somebody within the very high-income bracket. This can be because, within the liquid funds, the returns are taxed at 30% for a holding for less than 3 years, whereas arbitrage funds are ready to fetch the preferential tax treatment like an equity fund. So, thanks to the lower liabilities, their post-tax returns find themselves slightly higher. The fact is, these funds tend to be more highly volatile than liquid funds. Over very short periods of saying one month, are quite a few instances when they’ve delivered negative returns. So, that’s something that one simply must be cognizant off.
Key benefits of investing in arbitrage funds. Firstly, they create the most effective pricing volatilities. Arbitrage funds look for opportunities in price variations of equities across stock exchanges and markets both spot and future. For instance, A stock trading at Rs. 98 in NSE, trades at Rs. 100 in BSE. The fund leverages this variation for risk-free returns of Rs. 2, by purchasing from NSE and selling it at BSE. A particular stock currently trades at Rs. 97 within the spot commodities exchange. The identical stock trades at Rs. 100 within the future market. The fund would pick the stock from the commodity exchange and can simultaneously short a future contract i.e. it’ll sell the stock at Rs. 100 on contract expiry. this offers a risk-free return of Rs. 3 (100-97) which is independent of the worth on the settlement date. When the contract expires, both the costs coincide and therefore the two positions are squared up i.e. the share is sold within the commodities market. Investors ought to have a horizon of at least 6 months or more for leveraging the said mispricing.
Secondly, Arbitrage funds furnish the advantage of liquidity but make more sense when investors can stay invested for a minimum of 6 months. Thirdly, they provide tax efficiency, Tax-efficiency gives arbitrage funds a footing over pure debt funds. Arbitrage funds are hybrid funds investing in a mixture of equity of at least 65% and debt. For taxation purposes, they’re treated as equity funds and are subject to fifteen STCG tax where the holding period is a smaller amount than one year and 10% LTCG tax for gains exceeding Rs. 1 lakh where the holding period is quite one year. On the opposite hand, STCG taxes where the holding period is a smaller amount than three years from debt funds are taxed at applicable slab rates while LTCG taxes where the holding period exceeds three years are subject to twenty taxes with indexation benefit.