What are Arbitrage Funds & Liquid Funds

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31 JANUARY, 2022

In investing, countless options are available to individuals looking to grow their wealth. For those seeking relatively low-risk investments with easy liquidity, liquid funds have long been popular. However, a new market player, arbitrage funds, has been gaining traction as a potential alternative to liquid funds. These funds have been touted for their ability to provide stable returns while also offering the potential for higher yields.

But are arbitrage funds truly a better alternative to liquid funds? In this guide, we will delve into the details of both investment options and compare them in terms of risk, returns, and suitability for different investment goals.

What are Arbitrage Funds?

Arbitrage funds are investment funds that aim to generate returns by exploiting price disparities in different markets or assets. The basic principle behind arbitrage is to take advantage of temporary price differences to generate profits with minimal risk. In arbitrage funds, this strategy involves simultaneously buying and selling securities, such as stocks or derivatives, in different markets to profit from the price differential.

The underlying principle is to capture the price spread between the buying and selling, often within a short time frame. This strategy differs from liquid funds, which primarily invest in short-term, low-risk debt instruments and aim to provide stability and easy access to investors' capital.

While liquid funds focus on preserving capital and generating steady income, arbitrage funds seek to capitalise on market inefficiencies and volatility. The main difference lies in the investment approach, with arbitrage funds relying on active trading and exploiting market discrepancies, while liquid funds prioritise capital preservation and liquidity.

What are Liquid Funds?

Liquid funds are like supercharged savings accounts! They invest in ultra-short-term (up to 91 days) debt like treasury bills, offering high liquidity (fast access) and modest returns, beating typical savings account rates. They are a good option for parking emergency funds or making short-term investments.

Comparing arbitrage funds to liquid funds

Both Arbitrage and Liquid Funds are popular choices for parking short-term money, but they have key differences:

Aspect	Liquid Funds	Arbitrage Funds
Investment Strategy	Invest in low-risk debt instruments with maturities of up to 91 days	Exploit mispricing between cash and futures markets, typically fully hedging positions
Risk & Return	Very low risk with returns slightly higher than savings accounts (2-4%)	Almost no market risk, offering slightly higher returns than liquid funds (4-6%)
Liquidity	Highly liquid, redeeming in 1 business day	Highly liquid, but redemption might take 2-3 days
Choosing the Right Option	Emergency Fund: Opt for immediate access	Short-term goals (3-6 months): Both options viable; Arbitrage Funds might offer slightly higher returns with minimal risk. Tax efficiency: If in a higher tax bracket, Arbitrage Funds offer better long-term tax benefits

Note: Remember, consult a financial advisor for personalised advice based on your specific goals and risk tolerance.

Benefits of Arbitrage Funds

Arbitrage funds offer several benefits, making them a compelling investment option for individuals seeking consistent returns, a lower risk profile, and tax advantages.

These funds have the potential to provide steady returns even in volatile markets. Their unique strategy of capitalising on price disparities allows them to generate profits regardless of market conditions.

Arbitrage funds present a lower risk profile compared to traditional equity funds. By simultaneously buying and selling securities in different markets, these funds aim to neutralise market risk and focus on capturing the price spread.

Such funds offer tax advantages, especially for investors in higher tax brackets. The gains from these funds are treated as short-term capital gains, which are taxable at a lower rate than regular income. This can lead to significant tax savings for individuals in higher tax brackets, making arbitrage funds an attractive option from a tax planning perspective.

How do Arbitrage Funds Work?

The investment strategy of arbitrage funds revolves around taking advantage of price discrepancies between different markets or financial instruments. In the cash segment, arbitrage funds buy a security in one market and sell the same security in another, aiming to profit from the price difference. This strategy is known as cash arbitrage.

In the derivative segment, arbitrage funds employ a similar approach but with futures and options contracts. They take positions in the underlying asset and its derivative, such as a stock and its corresponding futures contract. By hedging their positions and capturing the price differential, they aim to generate profits from the arbitrage opportunity.

Note that while arbitrage funds offer several advantages, they also come with certain risks. These include execution risk, where trades may not be executed at the desired prices due to market volatility or liquidity issues, and regulatory risk, as changes in market regulations can impact the profitability of arbitrage strategies.

Tax Treatment of Arbitrage Funds

Due to their equity exposure, arbitrage funds are classified as equity funds for tax purposes. This classification has implications for the tax treatment of these funds. Regarding capital gains tax, short-term capital gains (STCG) tax applies if the holding period is less than one year, while long-term capital gains (LTCG) tax applies if the holding period is more than one year. The STCG tax rate is typically higher compared to the LTCG tax rate.

Tax laws are subject to change, and individuals should seek professional tax advice to understand the tax implications of investing in arbitrage funds. With potential changes in tax regulations, stay updated on the current tax laws to make informed investment decisions.

Ideal Investment Strategy for Arbitrage Funds

When considering an ideal investment strategy for arbitrage funds, one key aspect to analyse is the potential favorability of lumpsum investments compared to SIPs.

Lumpsum investments may be more advantageous for arbitrage funds due to their nature of taking advantage of price differentials in the market. Investors can immediately benefit from potential arbitrage opportunities and capitalise on market inefficiencies by investing in a lump sum.

On the other hand, Systematic Investment Plans (SIPs) involve spreading out investments over time, which may limit the ability to fully take advantage of short-term market fluctuations.

Additionally, consider the fund management dynamics of arbitrage funds, including higher expense ratios and exit charges. Due to the active management required for identifying and executing arbitrage opportunities, these funds tend to have slightly higher expense ratios than passive investment options.

However, the potential profits generated through successful arbitrage can outweigh the higher expenses, making it a viable investment strategy for certain individuals.

Regarding investment duration, arbitrage funds are typically recommended for investors with a medium to long-term investment horizon. The nature of arbitrage strategies requires sufficient time to capture and capitalise on price differentials.

While flexibility in entry and exit is a key feature of arbitrage funds, it is crucial to maintain a longer investment duration to potentially benefit from market inefficiencies and optimise returns.

Who should invest in Arbitrage Funds?

Investing in arbitrage funds can be suitable for investors with a specific investor profile. First, individuals with a moderate to high-risk tolerance may find arbitrage funds appealing.

These funds typically take advantage of short-term price discrepancies in the market, which may carry a certain level of risk. Therefore, investors who are comfortable with market volatility and who can withstand potential losses may benefit from these funds.

Secondly, investors with a medium to long-term investment horizon may find arbitrage funds suitable. While the primary goal of these funds is capitalising on short-term market inefficiencies, it is important to note that the benefits may accumulate over time. So, investors willing to remain invested for an extended period may potentially maximise the returns from these funds.

Lastly, individuals with a focus on tax efficiency may consider arbitrage funds. These funds are treated as equity funds for taxation purposes, meaning long-term capital gains are tax-free after one year of investment.

Factors to Consider Before Investing in Arbitrage Mutual Funds in India

Firstly, assess the prevailing market conditions. The success of arbitrage strategies depends on the presence of price discrepancies, which may vary based on market volatility and liquidity. Investors should analyse the overall market environment and consider whether it is conducive to executing arbitrage strategies.

Secondly, evaluating the historical performance of the fund is crucial. Investors should review the fund's track record, focusing on its consistency in generating returns and managing risk. This analysis should include assessing the fund's ability to capitalise on arbitrage opportunities and deliver competitive returns relative to its peers.

Furthermore, individual financial goals should guide the investment decision. Investors must determine their investment horizon, risk tolerance, and desired return expectations. Arbitrage funds are not immune to market fluctuations, and investors should align their investment strategy with their financial objectives.

Additionally, considering the expense ratio and other fees associated with the fund is important. Lower expenses can enhance an investor's overall returns, making it essential to compare the cost structure of different funds before selecting one.

Market Fluctuations and the Pandemic Impact

The global financial markets experienced significant volatility due to the COVID-19 pandemic. The uncertainty surrounding the pandemic and its economic impact on businesses and industries led to a sharp decline in equity markets worldwide.

Investors faced heightened market fluctuations, causing a reevaluation of their investment strategies. In times of uncertainty, investors seek safe havens for their capital, and debt instruments often emerge as favourable options. Debt is considered a safer investment during market turbulence due to its fixed return and lower risk profile than equities.

In particular, investors have traditionally favoured liquid funds by seeking stability and easy access to their investments. However, in recent years, a new alternative has emerged in the form of Arbitrage Funds. Arbitrage funds capitalise on market volatility and price differentials between various markets or assets, aiming to generate profits through low-risk trading strategies.

These funds allow investors to leverage market fluctuations and deliver steady returns in uncertain times. As such, arbitrage funds have gained attention as a potential alternative to traditional liquid funds, offering a different approach to navigating the market's unpredictability.

Let’s look at the Arbitrage Funds recommended by Kotak:

Arbitrage Funds	AUM (in Crs)	Exit Load	Annualised (%)
Arbitrage Funds	AUM (in Crs)	Exit Load	3M	6M	1Y
Aditya Birla Sun Life Arbitrage Fund - Growth	4352.95	Within 1M: 0.25%	8.06%	7.39%	7.45%
Edelweiss Arbitrage Fund - Reg - Growth	5078.84	Within 1M: 0.1%	8.36%	7.53%	7.55%
ICICI Prudential Equity - Arbitrage Fund - Reg - Growth	10785.00	Within 1M: 0.25%	7.97%	7.34%	7.45%
Kotak Equity Arbitrage Fund - Reg - Growth	21565.89	Within 30D: 0.25%	8.52%	7.78%	7.78%
SBI Arbitrage Opportunities Fund - Growth	7493.90	Within 1M: 0.25%	8.02%	7.34%	7.66%
UTI Arbitrage Fund - Growth	3579.95	Within 21D: 0.25%	8.18%	7.50%	7.50%

Data as on 29 Feb 2024

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Kotak Mahindra Bank Limited, AMFI Registered Mutual Fund Distributor. AMFI Registration Number (ARN) 1390.

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Frequently Asked Questions

Q: Are arbitrage funds better than FD?

A: Arbitrage funds and Fixed Deposits serve different purposes. Arbitrage funds can offer better post-tax returns and liquidity than FDs, especially for those in the higher tax bracket. However, FDs provide a guaranteed return and are safer.

Q: Is it good to invest in arbitrage funds?

A: If you want a short-term investment with moderate returns and relatively low risk, arbitrage funds are a good option. They are also tax-efficient if held for more than a year. But, your decision should align with your financial goals and risk tolerance.

Q: How risky are arbitrage funds?

A: Arbitrage funds are considered low-risk as they exploit price differences in different markets. However, they aren't risk-free. The returns depend on market volatility and the availability of arbitrage opportunities.

Q: What is the average return of an arbitrage fund?

A: An arbitrage fund's average return varies but is typically around 4-6% annually. However, past performance doesn't guarantee future results.

Q: Can arbitrage funds give negative returns?

A: While rare, arbitrage funds can potentially give negative returns if the anticipated price difference between the cash and futures market doesn't materialise. However, such instances are uncommon.

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Disclaimer: This Article is for information purpose only. The views expressed in this Article do not necessarily constitute the views of Kotak Mahindra Bank Ltd. (“Bank”) or its employees. Bank make no warranty of any kind with respect to the completeness or accuracy of the material and articles contained in this Newsletter. The information contained in this Article is sourced from empaneled external experts for the benefit of the customers and it does not constitute legal advice from Kotak. Kotak, its directors, employees and the contributors shall not be responsible or liable for any damage or loss resulting from or arising due to reliance on or use of any information contained herein.