If you’re looking to invest in equities but feel that current market valuations are a bit too high, and you’re thinking of waiting 3–12 months before entering, Arbitrage Funds can be a smart alternative to debt funds for parking your surplus money. This approach also allows for a Systematic Transfer (STP) into equity funds over time.
But what exactly are Arbitrage Funds — and how do these Funds work?
Arbitrage Funds are Equity Oriented Hybrid Funds. They make money by taking advantage of price differences for the same stock in two places – like between different stock exchanges or between the cash and futures markets. Let’s break this down with simple examples:
- Price Difference Between Stock Exchanges:
Sometimes, a stock is priced differently on the two stock exchanges. Say stock ‘A’ is priced at Rs 100 on BSE and at Rs 110 on NSE. The fund manager spots this difference and places a buy order on BSE and a sell order at NSE. Thus making a riskless profit of Rs 10 since the trade is placed at the same time.
- Price Difference Between Cash and Futures Markets:
Under this strategy, the fund manager buys a stock and sells its derivative or vice versa depending on the price movements of the two.
Say stock ‘A’ is priced at Rs 100 on NSE and the futures contract of the same stock is trading at Rs 90. Since the underlying of the futures contract is stock ‘A’ only, the fund manager spots this difference and buys the futures contract and sells the stock ‘A’, thereby making a riskless profit of Rs 10.
Why Consider Arbitrage Funds Over Debt Funds?
Here’s where Arbitrage Funds really shine- Taxation.
Unlike debt funds, which are taxed based on your income slab, Arbitrage Funds are taxed like equity funds.
- If held for less than 1 year: Taxed at 20% (STCG)
- If held for more than 1 year: Taxed at 12.5% (LTCG) on gains over Rs 1.25 lakhs
For investors in higher tax brackets, this can lead to significantly higher post-tax returns compared to debt funds. Let’s understand this with a simple example-
| FUND TYPE à | DEBT FUND (in Rs) | ARBITRAGE FUND (in Rs) |
| Initial Investment | 1000 | 1000 |
| Returns @ 6.5% | 65 | 65 |
| Tax @ 30% & 12.5% respectively | (19.50) | (8.125) |
| Post Tax Value of Investment | 1045.50 | 1056.87 |
If you’re looking for a Low Risk opportunity that provides Post-Tax Returns that are better than Savings a/c and Debt Funds, Arbitrage Funds deserve a spot on your radar.
Disclaimer: Mutual fund investments are subject to market risks. Please read the offer documents carefully before investing.
