The scheme aims to generate low risk returns for investors by predominantly investing in arbitrage opportunities in the cash and the derivative segments of the equity markets and the arbitrage opportunities available within the derivative segment and by investing the balance in debt and money market instruments. This NFO is a good low risk investment opportunity for investors, who usually park their surplus savings in savings bank accounts, FDs and liquid mutual fund schemes. Arbitrage funds enjoy considerable tax advantage over savings bank, FDs and debt funds. Also in the current environment, where credit risk is a major concern for debt fund investors, arbitrage funds are excellent alternative options because these funds do not have credit risk.
Arbitrage is risk free profit made by buying and selling the same underlying asset in different capital market segments. The most common form of arbitrage is cash and carry arbitrage, which exploits price differences of stock or index in the cash and derivative (F&O) market segments. We will understand how arbitrage works with the help of a simple example:
Let us assume that a stock is trading in the cash market for Rs 1,300. The August series future price of the stock in the F&O market is Rs 1,309. If the fund manager buys the stock in the cash market and sell the same stock in the futures market he/she can lock-in Rs 9 of risk-free profit. Why is the profit risk-free? It is because the trade is protected from any market movement (up or down) because the buy (long) position is completely hedged with the sell (short) position. Let us explain further.
The above illustration does not include the transaction related costs.
Investors should understand that cash price and futures price converge on expiry of the futures series. If the price of the stock falls to 1280, the investor will make a loss of Rs 20 in the cash market, but a profit of Rs 29 in the futures market; net profit of Rs 9. If the price of the stock rises to 1320, the investor will make a profit of Rs 20 in the cash market and a loss of the Rs 11 in the futures market; net profit of Rs 9. Sometimes investors need to wait till futures expiry to realize arbitrage profits. If the futures premium turns into a discount, the fund manager will square off both positions and book profit.
Arbitrage Funds are hybrid mutual fund schemes which aim to generate income by investing most of their assets under management (AUM) in arbitrage opportunities between cash and derivatives market and the balance portion of their assets in debt and money market securities. Arbitrage funds seek to generate returns commensurate with post tax accrual income without taking equity risks. It is important for investors to note that arbitrage position do not have either market or credit risks. As a result these schemes offer high degree of capital safety. Arbitrage fund returns have a strong correlation with market volatility. These funds usually give higher returns in bull markets when futures spread (difference between futures and cash market prices) is higher. However, arbitrage funds can generate stable positive returns even in bear markets.
One of the main advantages of investing in arbitrage funds is that these schemes enjoy equity taxation. Equity taxation is much more beneficial for investors compared to traditional fixed income or debt mutual fund taxation.
Interest paid by bank FDs and most Post Office Small Savings Schemes are taxed as per the income tax rate of the investor. Similarly, capital gains from debt funds held for less than 3 years are taxed as per the income tax rate of the investor. Short term capital gains from arbitrage funds (investment held for less than 1 year) are taxed as 15%.
Long term capital gains from arbitrage funds (investment held for more than 1 year) are tax free up to Rs 1 lakh of capital gains in a financial year. Long term capital gains in excess of Rs 1 lakh are taxed at 10%. In the case of debt funds, long term capital gains period is 3 years and long term capital gains are taxed at 20% after indexation. Dividends paid by debt funds are tax free in the hands of investors but the AMC has to pay dividend distribution tax (DDT) at the rate of 34.944% for companies and 29.11% for individuals / Hindu Undivided Families (HUF) before paying dividends to investors. One the other hand, for equity funds the applicable DDT rate for companies and individuals / HUF is 11.648%. You can see that equity taxation for different investment tenures and dividends is more beneficial than debt taxation.
Investors should note that the above tax calculations are purely for illustrative purposes. In order to understand the actual individual tax consequences of their investments, investors should consult with their tax advisors.
Arbitrage funds are good low risk, tax efficient investment options for parking your surplus funds for short to medium tenures to earn stable returns. In the current environment where some debt funds have come under cloud due to a number of credit risk related events, arbitrage funds are good alternative investment options to liquid funds.
In this blog post, we reviewed the salient features of upcoming arbitrage fund NFO of ITI Mutual Fund. As mentioned a number of times in our blog you should always invest according to your financial needs and risk appetite. You should consult with your financial advisor accordingly.
Mutual Fund Investments are subject to market risk, read all scheme related documents carefully.
ITI Mutual Fund aims to offer high-quality investment solutions to investors seeking long term wealth creation. We have access to some of the finest minds in the Investment Management, Equity Research and Credit Research space that enables us to run a very unique investment philosophy and also deploy robust investment strategies that can stand the test of time. The agility, no baggage and fresh perspective can help investors get ahead in a rapidly evolving economy.
Welcome to your future, to ITI Mutual Fund.
Would you like to continue with some arbitrary task?
Would you like to continue with some arbitrary task?
Send this article to the following email id.