What are arbitrage funds?

What are the arbitrage funds? Is it possible to lose the money invested in them?
- Jayshree

In the last 15 years, arbitrage funds haven't lost money but mutual funds are subject to market risks and one should not forget it ever. Arbitrage funds have been designed in a manner that you don't lose money. These funds invest in equities as well as in a corresponding derivative. For example, let's assume that the share of the company X is trading at Rs 100 in the cash segment and its future contract is trading at Rs 110. An arbitrage fund will buy the share in the cash segment and at the same time, sell its derivative (future contract). So, in a month's time, this fund will pocket a gain of Rs 10. It is much like a "buy and sell" process. Such opportunities keep arising in the market on a daily basis and one has to stay alert. And precisely this is what these funds do.

Normally, such arbitrage doesn't generate extraordinary returns. The returns from these funds range somewhere around the returns provided by liquid or ultra-short-duration funds. The difference lies in the tax treatment of arbitrage funds. Our tax structure is such that since these funds invest in equity and equity derivatives, they are treated in line with the taxation of an equity-oriented fund. Thus, these funds are liable for a 10 per cent long-term capital gain if held for more than a year and 15 per cent short-term capital gain if held for less than one year.

If you derive a similar return from fixed deposits, the applicable marginal tax rate will be much higher. And similarly, for debt funds, the gain will be added to your income and taxed as per your tax-slab if held for less than three years.

This article was originally published on September 11, 2019.