Arbitrage Fund - Risk Free and Tax Free Investment

Arbitrage Fund - Risk Free and Tax Free Investment

Since Finance Minister of India has changed the tax provision for debt mutual funds in the Budget, arbitrage mutual funds have suddenly become the flavor of the season.

Arbitrage funds are categorized as equity funds but its near risk-free nature, along with its tax advantage against debt funds, has seen investors getting attracted to this fund after Budget. On returns side, arbitrage funds are comparable to that of debt funds.

An arbitrage fund is a type of equity mutual fund that tries to take advantage of the price differential (of the same asset) between two or more markets or market segments. Arbitrage funds have the potential to deliver better post-tax returns at a similar level of risk compared to debt funds (money market/liquid funds).

Arbitrage funds offer the benefit of equity funds in terms of taxation and returns are somewhere near 8 per cent or so in line with some of the debt funds.


ParticularsArbitrage FundFixed DepositsSaving Account
Return on Investment 7-9% 7-9% 3-4%
Tax on EarningsTax Free if held for more than 1 year. 15% tax if held for less than 1 year 30.90% 30.90%
Effective return after tax 7-9% 5.5 - 6.3% 2-3%
Complexity levelA bit complicated for layman to understandVery easy to understand Very easy to understand 
Suitable for 1 to 2 years of investment with tax free returns, high liquidity and better returns than saving bank account and FDA person in low income tax slab.A person in low income tax slab.
*The above chart has been prepared assuming that the investor is in the highest tax slab.


How Arbitrage Funds Work

Arbitrage funds exploit the difference in the price of a stock between cash and derivatives markets or even different stock exchanges such as BSE and NSE.

For example, the price of a stock quotes at Rs 100 in cash market and Rs 102 in futures market. The fund manager would buy in cash market and simultaneously sell in futures market to lock in a profit of Rs 2 per share.

Arbitrage funds work well in volatile markets as fund managers are able to capitalize on differences in prices of a stock between the equity market and the futures market. Arbitrage fund managers reduce the risk in equities by hedging them using derivatives.

Arbitrage funds also deploy surplus cash in debt securities and money market instruments.

Taxation

Arbitrage funds are categorized as equity funds from a taxation perspective. This gives arbitrage funds the benefit of zero taxes on long-term gains (holding period of more than a year). If the holding period is less than a year, capital gains (short-term) are taxed at 15 per cent.

In contrast, the government increased the long-term capital gains tax on debt-oriented mutual funds from 10 per cent to 20 per cent and changed the definition of 'long term' for debt mutual funds to 36 months from 12 months effective from July 10.  Short-term capital gains on debt funds are added to one's income and taxed as per the individual's income tax slab.

Interest receivable from bank is also taxable according to your income slab, therefore arbitrage fund is more tax efficient than fixed deposit. It is also competent to saving bank fund since it provides liquidity and tax efficiency.



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