What are Arbitrage Funds? Returns, Risks, Taxation

Arbitrage Mutual Funds, Arbitrage Funds, Arbitrage Funds Taxation

In my last blog Best Mutual Funds to invest in 2018, you would have seen a mention of Arbitrage Funds? Arbitrage funds are gaining popularity & the asset under management (AUM) of many fund houses under this scheme has grown multi fold in the year 2017.

What are Arbitrage Funds?

Arbitrage funds take advantage of the stock prices in the cash & derivatives market. Usually we have seen prices in the futures market tend to be at a premium to cash market, this has given birth to a new type of funds, Arbitrage Funds, wherein the fund managers try to capitalize such opportunities by exploiting the price difference and is a short term trading opportunity. You may also have noticed the price difference between NSE & BSE stock prices, which is also an arbitrage opportunity.

This rarely results in a loss, but the possibility cannot be ruled out. The arbitrage opportunity available in the market is limited and hence the return can reduce as the AUM for such funds increases.

Looking at the previous years data - the returns from best performing arbitrage funds have ranged from 6.5-8% annually. 

Now the argument can be liquid funds offer better returns!! Let's first understand what are liquid funds -

Liquid funds cater to your short term needs where you need liquidity & also the money should keep growing. Parking your surplus money for a short time-frame in liquid funds may seem like a good idea as they offer relatively better returns than bank deposits or arbitrage funds. 

Now, why should you be interested in Arbitrage funds when FD deposits give you 6.5-7% and liquid funds usually return 8-9% on an average? 

TAX!!, liquid funds are treated like debt funds for taxation - if redeemed before 36 months, you would have to pay short term capital gains tax & these are taxed as per your slab, which could be 5,20 or 30 percent. If you redeem post 36 months, these are taxes as long term capital gain of 20%, with indexation benefit. Hence, 8% earned on a liquid fund which is redeemed before 36 months  for an investor with 20% & 30% tax slab, will get a post tax return of mere 6.4% & 5.6% respectively.

Taxation on Arbitrage Funds

The Arbitrage funds are treated as Equity Funds for taxation. If you redeem these after 1 year, you are liable to pay a long term capital gains tax of 10% (effective 1st April,2018), which can effectively be 0% if you have redeemed the mutual fund units & your tax liability from equity capital gains is less than 1 lakh for the financial year. 

If redeemed prior to 12 months, you would have to pay 15% short term capital gains tax.

Below example will illustrate the returns from an arbitrage fund.

For simplicity i am considering the units are sold at the same NAV on 364th and 365th day. Considering units sold on 364th day to be liable as short term capital gain  & units sold on 365th day as long term capital gain.

Amount Invested100000
Annual Return8%
Amount after 364/365 days108000
STCG(15% for Arbitrage)106800
LTCG(10% for Arbitrage)107200
LTCG (If gains do not exceed 1 Lakh)108000

The overall profit considering 8% return would result to INR 8000 & a short term tax liability of 1200 at the tax rate of 15% if the units are sold after 364th day, which would mean a post tax return amount as 106800. However, if the units are sold on or after 365 days, the tax liability would be 800. Since long term capital gains from sale of equities have an exemption of 1 lakh in a financial year, hence if overall profit is less than 1 lakh - the overall return would stay at 8%. Isn't that amazing?

Best Arbitrage Funds to Invest in 2018 -

Mutual Fund Name1Y Return %3Y Return %5Y Return %
L&T Arbitrage Opportunities Fund - Direct Plan7.07%7.06%-
Reliance Arbitrage Advantage Fund - Direct Plan7.02%7.15%7.97%
Axis Enhanced Arbitrage Fund - Direct Plan6.92%7.17%-
Kotak Equity Arbitrage Fund - Direct Plan6.82%6.99%7.99%

*Returns based on NAV as on 4th April, 2018

One Liner Tip -

All investors who fall under 20 or 30% tax slab should prefer to invest in Arbitrage Funds for  their short term & risk free (almost risk free!) investments due to taxation benefits.

Mutual funds as an investment instrument has been gaining popularity over the years, thanks to the wide range of options available and the ease of KYC process. To know more about them, check out The Mutual Funds Sahi Hai campaign, launched by The Association of Mutual Funds in India (AMFI) at www.mutualfundssahihai.com

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