Arbitrage Funds

Arbitrage is a term used to describe the purchase of a product which is then immediately sold to make a profit. Arbitrage is popular in the stock market or as a means to make profit from goods being sold at differing prices in varying markets.

Let’s take an example of arbitrage. Suppose a tailor sells a shirt for Rs. 400/- the cost for him is Rs. 300/- He makes a profit of Rs. 100. One day when he at the cloth manufacturer, he meets another tailor who also makes shirts and sells. The cloth and accessories are the same, his fitting is also more or less similar, but he sells his shirts for Rs.250/- So our tailor to increase his profits, buys from the other tailor at Rs. 250/- and sells for Rs. 400, increasing his profit to Rs. 150/- per shirt. This is arbitrage, basically taking advantage of the price difference in the other market for the same product.

The above type of arbitrage is available in the financial markets as well. In the financial markets there are 2 types of markets, one is cash and the other is derivative. There is always a price difference in both these markets. So if one buys in the cash market and sells in the derivatives market it will be called an arbitrage trade.

Now if it was so easy everyone would have been doing it. But here is the catch. In the cash market you can buy today and sell tomorrow. But in the derivatives market it is a contract which is valid for a fixed period. One just pays a premium initially and at the end of the contract period, s/he has to settle it by paying the difference between the then prevailing price and the contract price. So if your bet goes wrong, you could lose big. But since you have done the opposite in the cash market, the loss will be minimal.

Arbitrage funds returns are very similar to debt fund or fixed deposits, but this product is treated as an equity product. The reason is tax.

Therefore it is very important that you know about the tax treatment and investment options before making any investment decisions.

For income tax purpose, as mentioned above arbitrage mutual funds are classified as Equity oriented funds.

·         Long Term Capital Gains on Arbitrage Fund

      o   If you make a gain / profit on your investment in an Arbitrage Mutual Fund scheme that you have held for over 1 year, it will be classified as Long Term Capital Gain.

      o   The long term capital gains on Equity oriented funds will be taxed at 10% if the total Long Term Capital gains is more than Rs. 1 Lakh in a year. It is tax free till March 31, 2018.

·         Short Term Capital Gains

   o   If your holdings of an Arbitrage Equity mutual fund scheme are less than 1 year old i.e. if you withdraw your mutual fund units before 1 year, after making a profit, then the profit will be considered as Short Term Capital Gain.

      o   The capital gain tax rate of 15% is applicable on Short Term Capital Gains of Arbitrage Fund.

   o   Kindly note that interest income on Fixed Deposits will be charged at as per your income tax slab rate.

   o   The Short term Capital gains on Debt mutual funds too are taxed at as per your income tax slab rate if the holding period is less than 3 years.

So, as per the current tax laws, the Arbitrage Funds have clear tax advantage over Fixed Deposits or Debt Mutual Funds.