We all are aware of the universal fact that equity funds are volatile and very risky for the short term, debt funds are somewhat deserted by return-conscious investors looking to park money for a short duration. When such things, come the way, investors with a bit higher risk appetite can explore arbitrage funds to park short-term money. We can explain this better with the benefits and concerns of arbitrage over the short term.
What is Arbitrage Fund?
Initially, the arbitrage funds drive the eminent of pricing inconsistency as they seek opportunities in price variations of equities across stock exchanges both BSE and NSE, and spot and future markets. Let’s assume, a stock trading at Rs. 194 in NSE, trades at Rs. 200 in BSE. The fund anchorages the difference for a risk-free return of Rs. 6 by purchasing the stock from NSE and selling it at BSE.
How Does it Work?
An XYZ stock presently trading at Rs. 47 in the spot market. The same stock trades at Rs. 51 in the future market. The fund would position long in the spot market and will play a short position in a futures contract i.e. it will sell the stock at Rs. 51 on contract expiry. This gives a risk-free return of Rs. 4 which is maverick of the price on the settlement date. When the contract concludes, both the prices harmonize and the two positions are squared off i.e. the share is purchased from the future market and sold in the spot market. The net gain or loss within any scenario is similar to the initial variation in spot (Rs. 47) and future market (Rs. 51).
Benefits and Drawbacks
Investors should hold for a horizon of 6 months or more for resisting misalignment. Arbitrage funds have the ability to ease the liquidity and are sensible when investors can stay invested for a minimum of 6 months. Arbitrage funds have an edge in tax efficiency compared to pure debt funds. Arbitrage funds are hybrid funds with a mix of 65% equity and debt for the rest. For taxation purposes, they are treated as equity funds and are subject to 15% STCG tax and 10% LTCG tax for gains exceeding Rs. 1 lakh for 1 year and 20% taxes with indexation benefit for 3 years.
These funds aspire to make the best of pricing variation in the midst of market volatilities. They primarily focus on upgrading the difference which fluctuates with market movements.
Arbitrage funds involve fees associated with frequent trading. Owing to these pulsations lead to considerable transaction costs and a higher turnover ratio. This proportion indicates the pace at which a fund changes its portfolio in a particular year. Further, vindications are usually subject to exit loads depending on the investing horizon. Cost specifications must be prudently channelized for exploring their effect on the overall returns.