Arbitrage funds attract no dividend distribution tax and no LTCG tax for holdings beyond one year
The term arbitrage refers to simultaneous purchase and sale of assets to profit from a difference in the price. It is a trade that profits by exploiting the price differences of identical or similar financial instruments on different markets or in different forms.
Arbitrage funds play on the price differential between equity shares in the cash market and stock futures market. Typically, the price at which a stock is sold in the stock futures market is higher than the price at which it is purchased in the cash or spot market. The price difference represents the ‘cost of funds’ for the remaining number of days between the date of transaction and ‘expiry’, which is the last working Thursday of the month.
The concept of ‘cost of funds’ is that a trader is deferring a transaction from the current date to the last Thursday of the month. For this deferment, some other trader is stepping in and conceptually ‘funding’ it. When a trader in the market is purchasing a stock in the stock futures market, the arbitrage fund manager is selling the stock at a price higher than the cash market, and this price differential represents the ‘cost of funding’.
The definition of an equity fund, for tax treatment purposes, is 65% or more of the portfolio, which is measured as an average of last one year, on the first and last working day of the month. For 65% or more of the portfolio in an arbitrage fund, the fund manager purchases equity stocks and sells the same stock in the futures market. The sale position in the stock futures market is a little higher than the purchase position, which is the fund’s earning. The balance is invested in money market or debt instruments.
These funds are technically equity funds and enjoy the tax efficiency of an equity fund over debt funds. There is no long term capital gains tax for holdings of more than one year, no dividend distribution tax and short term capital gains tax for holdings of less than one year is 15% plus surcharge and cess. Arbitrage funds are suitable for fixed income oriented investors. Conservative fixed income investors can look at arbitrage funds for an allocation in the portfolio, since there is no open position in equities as it is completely hedged.
For the purpose of comparison of returns with fixed income funds, it is to be seen like this: Let us say you are an individual and the DDT rate is 28.84%. Let us assume the debt fund generates a return of 8.78%. Hence your net return is 8.78% minus 28.84% of that, i.e., 6.25%. An arbitrage fund being free of DDT needs to generate only 6.25% return to match the debt fund. Now, a return of 6.25% from arbitrage fund is likely, but a return of 8.78% from debt fund is ambitious in the current context. Hence arbitrage funds look attractive.
There is a variant of arbitrage funds floated recently by an AMC, where 20-25% will be hedged against Nifty Futures (and not stock futures) and the fund manager will purchase stocks that may not exactly match the Nifty basket. The purpose is to outperform Nifty through selection of stocks. If the fund manager outperforms Nifty, this fund will outperform conventional arbitrage funds.