Does Investing In An Equity Arbitrage Fund Make Sense In A Volatile Equity Market?

There are more than 1,000 mutual fund (MF) schemes by more than 40 different MF companies. So much choice can be especially confusing for new investors, such as Gen Z investors, who are new to the world of investing. One of the categories of funds to look at is arbitrage fund as they uniquely carry low risk and enjoy equity taxation. 

What Are Equity Arbitrage Funds? 

Equity arbitrage funds are the only MFs that carry low-risk labeling despite being equity funds. As the name suggests, arbitrage is a practice wherein a person takes advantage of the difference in the price of the same securities in two different markets, say, spot market, futures market or two exchanges. These funds essentially use this ‘mis-pricing’ to buy and trade securities at different prices across different markets.  

Equity arbitrage MFs aim to give risk-free returns by playing on the price difference of equity shares in different markets and/or segments, for example, the BSE versus the National Stock Exchange, or spot market (cash segment) versus futures market (derivatives segment). “Simultaneous buying and selling positions are created in an underlying share or its derivative in different market segments. This ensures that the positions are 100 per cent hedged to earn a risk-free profit,” says Piyush Nagda, head-investment products at brokerage and financial services firm Prabhudas Lilladher. 

How Does It Work?  

Let us take an example. Suppose the stock price of ABCD company today is Rs 2,418 in the cash segment and Rs 2,428 in the February futures segment. The equity MF’s fund manager will buy ABCD stocks in cash and sell in the futures segment keeping the quantity same in both trades. This difference of Rs10 is the gross profit of this trade. This is how equity arbitrage funds achieve a lower risk profile. Since the positional trade is fully hedged against any unforeseen fluctuation in price, there is essentially no loss to be incurred.  

“Cash and carry arbitrage, i.e. spot versus future, is one of the most widely used strategies by arbitrage funds. Say, the price of a share of X company in the spot (cash market) is Rs 500 and the price of its futures in the derivatives market (futures and options segment) is Rs 503. You can lock-in Rs 3 profit per share by simultaneously buying in the cash market and selling in the derivatives market,” explains Nagda. “The profit due to price difference on the trading day will accrue irrespective of the price movement of the share because on expiry of the futures contract (last Thursday of the month) the cash price and future price will converge and become same,” he adds.  

If the fund manager does not find any arbitrage opportunities, then the idle cash is invested in very short-term securities such as call money market or overnight securities to generate interest income. This is why equity arbitrage funds have high cash holding compared to other types of equity funds. 

How Are These Funds Taxed? 

Equity arbitrage funds are considered at par with liquid funds while enjoying equity taxation rules. If you sell your arbitrage fund units with gains within 12 months, then short-term capital gains tax will apply. Currently, the rate of short-term capital gains tax on equity funds stands at 15 per cent. But in case of debt funds, it is as per your tax slab. “In case of debt funds, short-term capital gain gets triggered on sale/redemption within three years,” says Nagda. So, arbitrage equity funds also offer an advantage in terms of when you sell your units.  

To learn more about how your investments are taxed, click here

Things To Look Out For 

Investors must note that equity arbitrage funds returns are lower; similar to what liquid funds give, and not what equity funds give. Also, these funds work on the basis of arbitrage opportunities. While this has not happened yet, but in the long run, as the assets of these funds increase, there may be fewer arbitrage opportunities.