Arbitrage funds are hybrid mutual funds that seek to make money from price differentials in the cash and futures market. The fund buys a cash-market share and sells its futures contract at the same time. If both prices converge near expiry, then the price gap can become a profit. A part of the fund can also be held in debt or money market assets.
These funds are not seeking to profit from a steep rise in share prices. They are looking for stable, tax-aware returns through hedged equity trades. Term and risk level can be used for the right goal and they can support long-term plans.
1. Understand How Returns Work
If a share is quoted at Rs 100 in the cash market and Rs 102 in the futures market. The fund could buy the share at Rs 100 and sell its future at Rs 102.
At expiry, both prices tend to meet up. The fund then closes both positions and tries to capture the price spread after trading costs.
The size of such gaps varies. Big gaps can open up room for income. Narrow gaps can restrict the return. The debt portion of the fund can also influence the final outcome.
2. Provide the Fund With a Clear Role
Arbitrage funds are suitable for money which can be invested for a period of six to twelve months. A shorter holding period may attract exit load, tax or weak market spreads. Exit load norms are subject to change based on schemes.
These could be in the low risk part of a long term portfolio. For example they may have money set aside for a planned home purchase, education fee, tax payment, or future transfer to equity.
Arbitrage funds, however, should not replace equity funds used for wealth creation in the long-term. Their return sources and risk structures are different.
3. Performance Throughout Market Cycles
Don’t pick a fund because it has done well recently. Check out its performance in stable and turbulent market conditions.
Check out its one-year, three-year, and rolling returns. A steady record can demonstrate how the fund reacted to changes in the cash and futures price gaps.
Also, check the fund’s size, cash position, allocation to debt and the credit quality of debt assets. Read the scheme factsheet and portfolio report . The documents specify how much cash and debt securities and how much money is in hedged equity trades.
4. Control Investment Expenses
Costs erode the earnings generated by each price gap. Before investing, check the expense ratio, exit load, tax effect and other charges of the scheme.
There is no distributor commission on a direct plan. So it might have a lower expense ratio than a regular plan. A direct plan is best suited to investors who can study funds and manage transactions without distributor support.
Frequent buying and selling, however, may interfere with the compounding process. Every sale can also create a tax liability. Set a target date and hold the units until that date unless the fund strategy/risk or financial goal changes.
5. Structure the Holding Period for Taxation
Arbitrage funds also qualify as equity-oriented funds if they adhere to the mandatory equity allocation norms.
If the units are sold within a period of twelve months the gains will be treated as short term capital gains. Such gains are taxed at 20% plus applicable cess and surcharge.
If the units are held for more than 12 months, the gains are taxed as long-term capital gains. The gains in excess of the annual limit of ₹1.25 lakh are taxed at 12.5% under Section 112A.
The tax outcome depends on the holding period, total profit and other capital gains booked during the financial year. Before redemption, tax laws should be checked.
6. Invest Through the Right Method
If you have the cash and a target date in mind, you can invest a lump sum. A monthly investment can be a way to start a fund for a planned expense.
An investor may have a large investment in an arbitrage fund and may shift fixed sums into an equity fund over a couple of months. This process is known as a systematic transfer plan.
It can spread out equity purchases over multiple dates. But in each transfer it is treated as a redemption from the arbitrage fund. It could cause capital gains tax.
7. Review the Fund at Regular Intervals
Check the fund once or twice a year. Watch its return after tax and expenses. Compare the result to the financial goal, not the stock market index.
If the goal is close, the scheme is no longer in line with the plan or the risk profile is changed, redemption may be contemplated.
Conclusion
Arbitrage funds can generate long-term returns by hedging trades, controlling costs, planning taxes and holding in a disciplined manner. The key steps are: know the strategy, select an appropriate holding period, consider expenses and debt quality, avoid frequent redemptions and conduct set reviews.
Their value is in a defined role in a larger portfolio of mutual funds.