What are Equity Arbitrage Mutual Funds? How do they compare with Liquid Mutual Funds?


What are Equity Arbitrage Mutual Funds?

Equity Arbitrage Mutual Funds, like several Debt Funds, aim to provide FD like returns.

But unlike Debt Funds, they do this not by investing in bonds and deposits but by arbitrage-trading in stocks and derivatives (hence the name Equity Arbitrage funds).

This makes them eligible to be taxed like Equity Mutual Funds (15% STCG tax, 10% LTCG tax) which is typically lower than the taxation faced by Debt Mutual Funds (STCG tax as per income tax bracket, 20% LTCG tax after indexation) and FDs (tax as per income tax bracket).

This tax advantage over Debt Funds and FDs is the main reason why Arbitrage Funds exist, even though they aim to provide similar pre-tax returns.

For eg ICICI Equity Arbitrage Fund has given returns since launch of around 7.6% - similar to an FD only.

ICICI-Arbitrage-Returns-Since-inception

How does an Arbitrage Fund generate returns?

In order to understand the risk in Arbitrage funds, one needs to first understand how they generate returns via arbitrage-trading.

Parallel to the stock market, there is a 'derivatives' market where Futures and Options on the stocks are traded.

A derivative contract typically represents a bet on where the stock will trade by the end of the month.

The price of the derivative contract is a function of the price of the underlying stock, time remaining to end of month, and the prevailing interest rate (and some other factors).

The important part is this - in arbitrage trading, the fund manager will typically buy a stock, say Reliance, and simultaneously sell a derivative contract (futures & option) on that stock, thus eliminating the stock market risk but capturing the interest rate.

So, in short, Debt Mutual Funds aim to capture the interest rate via investing in bonds and deposits etc, whereas Arbitrage Mutual Funds aim to capture the interest rate by arbitrage-trading in stocks and derivatives.

Risk in Arbitrage Funds

However, there are no free lunches. Arbitrage Funds do have a higher risk than comparable Liquid Debt Mutual Funds.

Because Aribtrage Mutual Funds generate returns by trading in stocks and derivatives, even though they don't carry an overall stock market exposure risk (because of arbitrage-trading), there can be times when the returns are negative.

For eg, their arbitrage-trading may not perfectly eliminate stock risk or the futures of a stock may deviate from their normal pricing patterns during extreme market scenarios (eg 2008-2009).

For example, this is for ICICI Prudential Equity Arbitrage Fund:
ICICI-Prudential-Arbitrage-Fund---worst-returns

Comparison with Liquid Funds

Returns

The returns of Liquid Debt Funds and Equity Arbitrage Funds are similar.

Risk

Arbitrage Funds are slightly riskier than Liquid Funds because their return generation depends on how well they can keep arbitraging between stocks and derivatives while hedging their market risks so as to be not dependent on the overall market movement.

Due to this they can have more number of negative days than a liquid fund, although eventually they may recover.

Note: Even liquid or short term debt funds can have some days of negative returns - so it is just a matter of degree.

You can get a better idea by looking at these two graphs - the first one with slight zig-zags is an arbitrage fund and the second one is a liquid fund.

ICICI Arbitrage Fund 1 year returns graph
Arbitrage-Funds-zig-zag

ICICI Liquid Fund - 1 year returns graph
Liquid-Fund-smooth

Taxation

Equity Arbitrage Funds are taxed like Equity Mutual Funds - 15% STCG tax for investments held for less than 1 year and 10% LTCG tax for investments held for 1 year or more.

Dividends in Equity Arbitrage Fund are taxfree in the hands of investors but they are liable for a dividend distribution tax of 10%.

Liquid Debt Funds are taxed like Debt Mutual Funds - 5%/20%/30% tax as per your income tax bracket for investments held for less than 3 years and 20% tax after indexation for investments held for 3 years or more.

Dividends in Liquid Debt Fund are taxfree in the hands of investors but they are liable for a dividend distribution tax of 25%.

Sample calculation:
Amount to be invested: 1 lakh
Income tax bracket: 20%
Pre-tax returns: 7%

Equity Arbitrage Funds:
Pre-tax returns: 7% of 1 lakh = Rs 7,000
Tax: 10% of Rs 7,000 = Rs 700

Liquid Mutual Fund:
Pre-tax returns: 7% of 1 lakh = Rs 7,000
Tax: 20% of Rs 7,000 = Rs 1400

So in this case, in a year you would save about Rs 700/lakh as tax by investing in Arbitrage Mutual Fund as compared to a Liquid Mutual Funds.

Exit Load

Arbitrage funds typically have a small exit load (eg 0.25%) upto a 1 month period.

Liquid Funds typically have no exit load.

Liquidity

There are no lock-ins in either type of funds. However, redemptions from Equity Arbitrage Mutual Funds will follow a timeline of 5 business days while redemption in Liquid Debt funds are processed faster eg in 1-2 business days.

Table: Comparison between Equity Arbitrage Mutual Funds and Liquid Debt Mutual Funds

Equity Arbitrage Fund Liquid Debt Fund
Returns Similar to FD Similar to FD
Risk Low but more than Liquid Fund Minimal
Taxation Like Equity Mutual Fund
15% STCG, 10% LTCG
Like Debt Mutual Fund
5%/20%/30% STCG according to income tax bracket, 20% LTCG with indexation
Exit Load 0.25%, typically for 1 month None
Liquidity No lock-ins, redemption within 5 business days No lock-ins, redemption within 2 business days

Conclusion

We generally don't recommend Arbitrage Funds over Liquid Funds because the tax saving is marginal and they have slightly higher risk than liquid funds as arbitrage funds invest in equity derivatives etc.

However, if you are okay taking on some extra risk in order to save tax, then you can invest in Arbitrage Funds.

Remember - risk comes from not knowing what you are doing. :)