Arbitrage Funds are mutual funds with an objective to profit from inefficiency in the price of securities in two different markets. We look at their taxation, meaning and difference with liquid funds in this post. The fund invests in equity and debt instruments. The fund manager applies the arbitrage strategy in the equity portion of the fund and for debt portion; it is invested in short-term debts and liquid funds. The profit from arbitrage fund is riskless. The difference in price of securities in two markets in a small range, and it quickly narrows down when a large volume of new positions are added for possible arbitration. Arbitrage means the difference in the price of a security/commodity in two different markets and the person who does arbitrage is known as, arbitrageur. An arbitrageur in the market always finds for inefficiencies in the market. They purchase a security from the market at a low price and sell it at a higher price in another market. The difference in price is the profit. Arbitrage is regarded as riskless profits. This forms the basic premise of how Arbitrage Funds work. How Arbitrage funds work: Inefficiency in price is present in every market. In the financial market, arbitrage strategy can be applied by purchasing stock in the Cash market and selling it at derivatives market at a higher price. For example: A stock is trading at NSE cash market at Rs.1000 and in Future Market its price is 1200, then the fund manager will buy the stock from the Cash market and simultaneously they will sell the stock at future market. Here Rs 200 is the profit for trade. As the future market has an expiry date for the contract, the fund manager will sell the stock at cash market previously it has bought and will buy the stock in the future market, to cover the position. As the expiry date in Future market nears, the price difference also narrows down and trades at the same price in both markets. The transaction cost in arbitrage funds is higher because it involves buying and selling of securities in two different markets and has to cover the position at the end of expiry of the future contract. Arbitrage Funds Risk & Return Arbitrage funds carry a moderate to low risk to investment. Opportunities for arbitrage comes when there is volatility in market, stable market does not provide much opportunity for arbitrage. The risk associated with equity holdings are reduced by hedging against the derivatives. The main objective of the funds is to generate a maximum return with less risk associated. Historically, top performing arbitrage funds have given a return of 7-9% from its investment 5-10 year period. The return of mainly depends on the ability of the fund manager to spot arbitrage opportunities in the market. More the opportunity more is the return. Arbitrage Funds Taxation In terms of return, Arbitrage funds and Debt funds give a similar return but in terms of taxation Arbitrage funds score over debt funds. Arbitrage funds are considered as equity funds because a fund with more than 65% holding in equities is classified as an equity fund. In, equity fund the investment over a period of 1yr is considered as a Long term and is tax-free. For investment under 1yr period, the gains are taxed at 15% as short-term capital gains tax. But for debt funds, Investment over 3 yrs is considered as a long term and it is taxed at 20%, after indexation benefit. For a period of less than 3yrs is considered as a short term and gain is taxed at 10%. Comparison between Liquid Fund and Arbitrage fund Liquid Fund: Liquid fund invests in money market securities like a certificate of deposits, Treasury bill, term deposits with maturity up to 91 days. These funds are highly liquid in nature and carry low risk to investment and have no exit load on redemption of the investment. These funds are suitable for short term period and to manage short-term liquidity requirement. The investment can be redeemed within 24 hrs. Arbitrage Fund: Its portfolio is a mix of equity and short-term debt instrument. It is suitable for an investment period of 1-3 yrs and carries moderate to low risk to investment. Most arbitrage funds have exit load of 0.25% to 0.50% for 3months and it takes 3-4 business day to redeem the investment. The main difference between the two funds is the taxation of gains which is discussed earlier in the article and due to taxation benefit, lately arbitrage funds have able to increase their AUM. Conclusion In a first look, arbitrage funds seem to have a more complex investment strategy, but on a closer look, it's not very difficult to get into with its investment strategies. The fund is not suitable for long-term wealth creation as there are many other options in equity funds with a better return in long term duration. It's ideal for investing the surplus money for shorter duration in a tax efficient way compared to fixed deposits and one has to stay invested for more than 1yr time period to get the benefits of taxation. Investors should also note that the fund does not favor any specific bull or bear market. The fund performs well only in volatile markets as the probability of price difference increases.