Taking Advantage Of Arbitrage Funds

You can get a significant tax advantage in arbitrage funds if the holding period is over a year, but remember that it is not a substitute for liquid funds

- JOYDEEP SEN

In the May 2023 issue (http:// bit.ly/3CHOlly), we discussed some hybrid fund options that can replace debt in view of the changes in the taxation rules. We will now discuss arbitrage funds from the same point of view. They too come under the category of hybrid funds. Their taxation is similar to that of equity funds but they are less volatile than them. Let us look into the working of this category of mutual funds.

Arbitrage funds earn returns from the price differential between equity stocks in the cash market and stock futures market, for 65 per cent of the portfolio. 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. In the stock futures market, futures of multiple maturities are available. Usually, fund managers sell near-month contracts and not longer-maturity contracts. There is higher liquidity and better visibility in near-month contracts, such as potential corporate action from the underlying company.

The price difference between cash and futures represents the 'cost of funds' for the remaining days between the date of the transaction and the expiry of the futures contract the last working Thursday of the month. The concept of 'cost of funds' is that a trader or investor is deferring a transaction from the current date to the last Thursday of the month or till the expiry of the contract if Thursday is a holiday. For this deferment, other traders step in and conceptually 'fund' it. When a trader in the market purchases a stock in the stock futures market, the arbitrage fund manager sells the stock at a price higher than the cash market, and this price differential represents the 'cost of fund.