Before understanding what an arbitrage mutual fund is let us try to understand what a mutual fund is.
Knowledge Of Mutual Funds
What if you could invest your funds and have a professional manage them on your behalf? These kinds of services certainly exist, but they come with hefty capital or investment requirements. What if you could use such a service and benefit from expert money management even with a minimal outlay of cash? Well, investing in mutual funds is one way to achieve this.
A Mutual Fund Is What?
“Mutual fund” refers to a fund created as a trust to raise money through the sale of units to the general public or a specific segment of the public under one or more schemes for investing in securities, money market instruments, gold or instruments related to gold, real estate assets, and other assets and instruments as may be specified by the Board from time to time.
A mutual fund is essentially a shared fund into which investors make contributions, to put it simply. The total is then invested in accordance with the fund’s investment goal.
The funds could be used to purchase gold, real estate, bonds, money market instruments, equities, and other similar assets. These funds are run by investment professionals who aim to increase or increase investor capital through investments that are in line with the stated investment objective.
For instance, a debt fund will have as its stated purpose to invest in fixed income securities or assets such as bonds, treasury bills, and debentures. Similar to this, an equity fund will invest in equity-related securities such as convertible debentures, convertible preference shares, warrants with the ability to purchase equity shares, equity derivatives, and any other securities that the Board may from time to time specify.
Typical groups of mutual funds include:
- Funds that only invest in stocks and other equity-related securities are known as equity funds.
- Debt funds are funds that only invest in fixed-income securities.
- Funds that invest in short-term money market products are known as money market funds.
- To achieve balance, hybrid funds split investments between equity and debt.
How are mutual funds organised?
A trust that has a sponsor, trustees, Asset Management Company (AMC) and custodian is used to set up a mutual fund. The trust is created by a sponsor, who is comparable to a company’s publicist. For the interest of the owners of units, the mutual fund’s trustees hold its assets.
The securities of the fund’s various schemes are kept in the custody of the custodian, who is registered with the Securities and Exchange Board of India (SEBI). The trustees have broad control over the AMC in terms of supervision and guidance. They keep an eye on the operation and adherence to SEBI regulations.
The AMC hires qualified money managers who have experience investing in equities, debt, or both. These managers invest and manage the investors’ money on their behalf.
The AMC might provide a number of mutual fund schemes, each with a distinct investment mandate. Based on the mandate or purpose specified, an investor can select the plan in which he or she wants to invest.
All AMCs are governed by a Board of Directors and come under the SEBI (Mutual Funds) Regulations, 1996. The regulator or SEBI has set clear mutual fund regulations and requires all mutual fund schemes of an AMC to clearly spell out the fund’s objectives in its prospectus that an investor must read before he/she invests in a mutual fund.
What are the advantages of buying mutual funds?
One of the key advantages of investing in a mutual fund is that each investor (even with a small investment) gets access to professional money management and expertise. Also, it would be very difficult for an investor to create a diversified portfolio of investments on his own with a small amount of money. With mutual funds, each investor participates proportionally in the return the scheme generates.
Each unit gets a proportional share of gain (or bears loss) from the fund. There is a portfolio report generated for each investor, which tracks all investments and the returns generated by the mutual fund.
What Are Arbitrage Funds?
Investors searching for a more tax-effective alternative to liquid funds are increasingly turning to arbitrage funds. Recent investments in this sector are evidence of this tendency.
How do they work?
In the cash and derivative markets, arbitrage funds make money by taking advantage of mispriced opportunities between spot and futures pricing. There may be chances for arbitrage in the same stock between various exchanges or between the price of a security and its futures.
If stock X were to trade at Rs 200 on one stock exchange and Rs 202 on the other stock exchange, the fund manager would simultaneously purchase it one and sell it on the other one for Rs 202, earning Rs 2. Similar to this, a fund manager can purchase stock in the cash market at a spot price of Rs 1,000 while concurrently selling it in the futures market at a price of Rs 1,002, locking in a profit of Rs 2 over the course of the contract.
If the price difference between the spot and futures position of the following month’s maturity still remains on the date of expiration, the fund managers roll over the futures position and hang onto the spot market position.
Fund managers lock in profits by purchasing in the cash market and selling in the futures and options market, regardless of the security’s price movement.
Fund managers occasionally unwind both the spot and the future positions before the current-month future expires to increase profits or satisfy redemptions.
Opportunities For Arbitrage Produced By Corporate Activities Or Events
Rights Issue:
When a business requires additional funding, this is disclosed to its current investors. A current investor is given the opportunity or “rights” by the corporation to purchase additional shares for a reduced price for a predetermined amount of time. This is a chance for arbitrage since the investor can purchase shares below market value and then sell them at market value.
Merger Arbitrage:
It is the trading of the stocks of two merging companies depending on their share swap ratio in mergers and acquisitions (M&A).
Buyback Arbitrage:
When a firm announces a buyback of its own shares, buy-back arbitrage possibilities may arise as a result of the price difference between the buyback price and the trade price.
Key Characteristics Of Arbitrage Funds Includes
Risk
These funds are not subject to counterparty risk because the trades are conducted between various exchanges. As opposed to other equity mutual funds, there is no exposure to long-term risk.
Through low-risk buy-and-sell opportunities in the cash and futures markets, an arbitrage fund generates profits. Continually seeking out arbitrage opportunities is the biggest challenge for fund managers.
Return
Arbitrage funds offer respectable returns, particularly if the fund manager is knowledgeable. Arbitrage funds are known to offer returns in the region of 7% to 8% over 5–10 years historically. In a turbulent market, arbitrage funds are the ideal balance of debt and equity. Arbitrage funds do not offer assured returns, either.
Cost of Investment
The expense ratio is the annual fee that arbitrage funds charge, just like mutual funds. The expense ratio is a proportion of the total assets of the fund. The fund manager’s fee and fund management costs are included in the expense ratio. Exit loads on some funds range from 30 to 60 days.
Arbitrage funds are appropriate for investors with a short- to medium-term investment horizon (3 years to five years). You should hold onto your investment for at least 3-6 months because there is an exit load involved. High volatility is essential for the success of an arbitrage fund. As a result, one-time investments are preferable to systematic ones.
Arbitrage funds are appropriate for short- to medium-term financial goals. If you have spare money in your bank account, you can park it there to start an emergency fund and make more money off of it. Overall, adding an arbitrage fund to your investment portfolio is a wise move.
Taxes
If you invest in arbitrage funds for a period of less than a year, you will be subject to a 15 percent STCG (short term capital gains) tax, which is applied to equities funds for tax purposes. Long-term capital gains tax (LTCG) is imposed over a period longer than one year. Over Rs. 1 lakh in annual LTCG is taxed at a rate of 10%, without the benefit of indexation.
Performance
As on July 1, 2022, in the case of direct plans, Arbitrage Funds have delivered in the range of 2.57 per cent to 4.65 per cent over a one-year trailing period.
Exit Charges
Exit loads charged by arbitrage funds range from zero (for the redemption of up to ten per cent of units before thirty days) to two and a half per cent (if the money is redeemed before seven to thirty days) (differs across funds).
Cost Charged To Investor
These funds may charge 0.16 per cent to 0.60 per cent under direct plans, depending on the programme assets under management. Charges for standard plans might range from 0.80 per cent to 1.5 per cent.
Arbitrage Funds V. Liquid Funds
What Are Liquid Funds?
In conclusion, Arbitrage Funds can provide better post-tax returns than low-risk debt funds with minimal volatility and risk.
How Do Liquid Funds Work?
Liquid funds are debt funds that invest in treasury bills, commercial paper, government securities, corporate bonds, and other debt and money market assets.
The portfolio of a liquid fund matures in 91 days (on average). Due to this, it is the appropriate investment for short-term holdings lasting between one day and three months. Returns from liquid funds are typically in the range of 4% to 6%.
In order to store excess cash or transfer assets to an equity fund using a Systematic Transfer Plan, investors are known to rely on liquid funds for the short term.
Due to their short maturity period and the high calibre of solid debt instruments they invest in, liquid funds are regarded as some of the most reliable and secure mutual funds.
Key distinctions between liquid funds and arbitrage funds
We’ve discussed the general characteristics of liquid funds and arbitrage funds, including what they invest in. Let’s now discuss the key distinctions between liquid funds and arbitrage funds.
First distinction: Risk
Compared to arbitrage funds, liquid funds are thought to be safer. A liquid fund makes investments in short-maturity debt instruments (91 days). A fund that invests in arbitrage opportunities also makes equity investments.
Over the long term, returns from liquid funds and arbitrage funds both range from 4 to 7 per cent. Arbitrage funds, on the other hand, can leverage these opportunities to provide superior short-term returns.
Second distinction: Tax
Depending on your tax level, arbitrage funds might be more tax-efficient than liquid funds. This is due to the tax treatment of arbitrage funds as equity funds.
Third difference: Costs
Due to their reliance on the fund manager’s ability to benefit from arbitrage opportunities, arbitrage funds may have a higher expense ratio than liquid funds.
Fourth Distinction: Liquidity
As their name implies, liquid funds are more liquid than arbitrage funds. A liquid fund allows you to withdraw your funds in as little as one to two days, but an arbitrage fund may require three to five days. Even some liquid investments have the option of instant redemption.
Are Liquid Funds Better Than Arbitrage Funds?
Comparatively speaking, an arbitrage fund might produce higher returns than a liquid fund basis their historic performance. But compared to an arbitrage fund, a liquid fund typically has more stable and predictable returns.
In comparison to arbitrage funds, liquid funds have significantly higher liquidity. The majority of liquid funds don’t impose an exit fee upon redemption after seven days. But when it comes to arbitrage funds, typically there is an exit cost.
However, because arbitrage funds are taxed similarly to equities mutual funds, they are more tax-efficient than liquid funds. Finally, depending on your objectives, you should decide whether to invest in either fund.
Did you know? You can now invest in arbitrage funds on Kuvera:
Step 1: Download the Kuvera app or visit our website.
Step 2: Create your account on Kuvera by completing the mandatory KYC procedure. This will hardly take a few minutes. Once that’s completed, select the ‘Invest’ option on our homepage after which you can select ‘Mutual Funds’ and ‘Arbitrage’.
Step 3: Kindly go through the list of all zero-commission direct plans of Arbitrage schemes to start investing.
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