Arbitrage Funds

The Arbitrage Hybrid Fund is a category of mutual funds that focuses on investing in stocks and stock-related instruments, while simultaneously taking offsetting positions in the derivatives market to hedge against price differences. Such a move is called arbitrage.

The fund thus earns a risk-free return from the price differential by purchasing the stock in the cash market and simultaneously selling it in the futures market. Both trades are executed simultaneously; therefore, the fund does not incur directional market risk. The rest of the fund's corpus is typically invested in debt and money market instruments to achieve stable returns.

According to SEBI guidelines, at least 65% of the portfolio must be in equity and equity-related instruments (including arbitrage positions) for the fund to be considered an equity-oriented fund for tax purposes.

Arbitrage Hybrid Funds rely on inefficiencies in the stock market, specifically the difference between a stock's spot price and its futures price. The fund manager identifies such opportunities and executes a pair trade: buying in the cash market and selling in the futures market, locking in the spread as profit.

For example, if Stock X is trading at ₹100 in the cash market and ₹102 in the futures market, the fund buys at ₹100 and sells at ₹102. On the expiry date, both positions are squared off, and the ₹ two differential becomes the fund's return on that trade.

This process is repeated across multiple stocks to generate low but steady returns. In scenarios where arbitrage opportunities are limited, the fund may invest more in short-term debt instruments.

• Low Volatility: As the equity exposure is hedged through derivatives, the portfolio experiences minimal fluctuations.
• Liquidity: These funds are open-ended and offer high liquidity, with redemptions typically processed within one to two business days.
• Short-Term Investment Suitability: They are often used by investors to park funds for short to medium time frames, especially during uncertain or volatile markets.
• No Direct Market Risk: The arbitrage strategy eliminates exposure to direct equity market movements.

Arbitrage Hybrid Funds are ideal for:

• Conservative investors seeking higher returns than those offered by savings accounts or liquid funds, while minimizing equity risk.
• Investors seeking short-term parking options (3 to 12 months) that offer better post-tax returns than traditional fixed-income products.
• Individuals in higher tax brackets who want equity-like tax treatment on relatively safe investments.
• Risk-averse investors who want to start investing in equity-oriented funds without exposure to market volatility.

These funds are also suitable during uncertain or sideways market conditions, where volatility creates more arbitrage opportunities.

• Risk Mitigation: The arbitrage strategy hedges the equity exposure, making it nearly risk-free in terms of market movements.
• Tax Benefit: Since these funds qualify as equity funds, they enjoy favorable tax treatment. Short-term capital gains (if held less than 12 months) are taxed at 15%, and long-term gains (beyond 12 months) at 10% above ₹1 lakh.
• Stable Returns: Although the returns may be modest, they are stable and predictable. This is because of the nature of arbitrage and debt investments.
• Liquidity and Flexibility: There is no lock-in period, and units can be redeemed at any time, subject to exit loads as defined by the AMC.
• Diversified Portfolio: These funds invest in a wide range of stocks and bonds. This helps lower concentration risk.

• Limited Returns: Returns are usually low compared to pure equity or hybrid funds. They typically range from 4% to 7% each year, depending on market conditions.
• Exit Load and STT: Some funds may levy an exit load if redeemed within a short period (usually 30 to 90 days). Additionally, Securities Transaction Tax (STT) applies as they are equity-oriented.
• Interest Rate Risk (Debt Component): The debt portion of the fund may be exposed to interest rate fluctuations, which could impact returns in scenarios where interest rates rise.

These funds are not meant for aggressive growth. Historical returns have ranged between 4% to 6.5% annually, depending on arbitrage spreads and interest rates. During periods of high volatility, the spreads tend to widen, resulting in better returns.

Their real strength lies in delivering steady, low-risk, and tax-efficient returns, especially in comparison to debt mutual funds or bank FDs for short tenures.

Arbitrage funds are taxed as equity mutual funds:

• Short-term capital gains (STCG): Taxed at 15% if held for less than 12 months.
• Long-term capital gains (LTCG):Taxed at 10% on gains exceeding ₹1 lakh in a financial year after 1 year of holding.

This taxation makes them more attractive than short-term debt funds, which are taxed at the investor's applicable income tax slab.

These funds are a good option when:

• You have idle funds for a few months and seek better post-tax returns than FDs.
• Equity markets are volatile, creating arbitrage spreads.
• You're seeking an alternative to liquid or ultra-short-term debt funds that offers equity tax treatment.

You can invest directly through the AMC's website or via mutual fund platforms and advisors. Both lump-sum and SIP options are available.

Evaluate funds based on:

• Historical consistency of returns
• Low expense ratio
• Exit load structure
• Portfolio diversification and quality of underlying debt securities