Smart Investing: The Comprehensive guide to Arbitrage Mutual Funds
Embarking on a journey of smart investing involves making informed choices that balance risk and reward. One such option gaining popularity among investors seeking low-risk opportunities is Arbitrage Mutual Funds. In this comprehensive guide, we’ll explore the fundamentals of arbitrage funds, their unique characteristics, and how they present an appealing avenue for those prioritizing stability in their investment portfolio.
What are Arbitrage Mutual Funds?
Many investment experts believe that leveraging arbitrage opportunities is the best way to generate wealth. Arbitrage is about finding a price difference of the same security between two or more markets and capitalizing on it. As an investor, if you find the price of a stock to be different in the futures and spot markets, then you have an opportunity to capitalize on it. However, this requires a lot of research and understanding of the way the market functions. Not all investors have the knowledge or time to dedicate to research, and this is where Arbitrage Mutual Funds step in.
Arbitrage Funds are equity-oriented hybrid funds that leverage arbitrage opportunities in the market. These opportunities are typically in the form of difference in price in the spot and futures market for the same security. Such funds typically buy stocks in the spot market and sell the same stocks in the same quantity in the futures market at the same time, earning the difference between the selling price and the buying price of the share.
This is fundamentally different from any other form of investing where you purchase an asset and wait for it to grow in value before selling it. In an arbitrage fund, the fund manager invests in equities only when there is a definite opportunity to earn returns. If there are no arbitrage opportunities available, the fund invests in short-term money market instruments and debt securities. The critical point to note here is that the price difference is usually in line with prevailing short term interest rates with deviations based on supply and demand in the equities market.
Arbitrage funds offer low-risk investors an excellent opportunity to earn decent returns during times of high volatility. Additionally, they are taxed at par with equity mutual funds. Although using 65% of funds for arbitrage trades isn’t a regulatory requirement, it is a common practice that offers tax efficiency and better after-tax returns.The remaining assets are allocated to low-risk debt, such as short-duration bonds or term deposits.
Cash Market:
The cash market, also known as the spot market, is where transactions are settled on the spot. For example, think of the secondary equity markets. When you buy shares on the NSE, your account is debited with the funds, and your transaction is settled on a T+1 basis or on the next business day.
Futures Market:
A futures market, as the name suggests, is a market where you can buy the right to buy or sell an asset at a predetermined price on a future date. The prices of an asset in the futures market may be higher or lower than in the spot market, and this difference is what an arbitrage trade intends to capitalize on.
Benefits of Arbitrage Mutual Funds:
- Low-risk investment in a volatile market: Arbitrage mutual funds thrive on the uncertainty of market conditions. As prices fluctuate due to market volatility, these funds capitalize on the rising differential between the cash and the futures markets. Moreover, these short-term investments are typically low-risk since they engage in simultaneous buying and selling of shares to take immediate advantage of the price difference. Should there be a shortage of arbitrage opportunities, these funds balance the risk by adding stable debt securities to the portfolio.
- Tax-efficient investment: Considering arbitrage funds primarily invest in equities and equity-related securities – enjoying up to 65% exposure – they are treated like equity funds and taxed accordingly. If you stay invested for more than a year, your gains will be considered long-term capital gains (LTCG) and will be completely tax-free.
However, short-term capital gains (STCG) are taxed at 15%, and LTCG exceeding Rs.1,00,000 are taxed at 10%, without the benefit of indexation. So, if you are in a higher tax bracket, then investing in an arbitrage fund is better than putting your money in a debt fund and paying more tax on the gains.
Who should invest in Arbitrage mutual funds?
The risk profile of an arbitrage fund is similar to that of a debt fund. Arbitrage funds are ideal for investors who want to invest in equity but don’t want to bear the risks. In a fluctuating market, many risk-averse investors can park their money in an arbitrage fund and earn reasonable short-term returns.
Conclusion:
Arbitrage mutual funds emerge as a beacon for investors seeking a low-risk investment avenue that blends stability and tax efficiency. Smart investing begins with understanding the nuances of your investment choices, and arbitrage mutual funds stand as a compelling option for those prioritizing stability and risk management.
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