Fund managers try to take advantage of differentials in current prices and future prices of a security. For example, a fund manager can buy shares in the cash market and sell the same stock and the same quantity in the futures or derivatives market, earning the differential without taking any risk.
This can be further explained with an example. Let’s assume that stock A is trading at Rs 100 in the cash market but the price of futures expiring next month is Rs 105. So fund manager will buy the specified quantities of the stock in cash and simultaneously sell in the futures market. Thereby earning a return of Rs 5 when the settlement takes place on expiry. A reverse transaction is also possible if the prices in the futures market of security are lower than the cash prices.
Thus, market volatility is a great friend of Arbitrage Fund Manager, as the differentials between cash and futures markets tend to amplify during the periods of volatility. Also, speculative activity is on the rise during the period of market volatility, so demand for security in the futures market could be higher than in the cash market, leading to a higher differential.
Arbitrage Funds also keep some part of funds in the high-quality debt and money market instruments to provide stability to returns. This also helps them ready availability of funds in case there is a sudden opportunity to be exploited.
During the current phase of the low-interest scenario, most short-term instruments like Liquid Funds are generating low returns of around 3 percent pa. Similarly, returns on short-term bank deposits are also very low.
While the Arbitrage Funds are able to generate higher returns in the range of 5-6 percent pa taking advantage of the volatility in the market. Stock markets have been volatile in recent months due to both negative and positive news flows. On one side, there has been uncertainty about the economy due to the massive 2nd wave of Covid, on the other hand, there is a lot of liquidity driving the market along with the expectation that economy will recover faster than anticipated.
Taking advantage of the situation, smart investors have started moving money into Arbitrage Funds from other short-term avenues. Liquid Funds saw a net outflow of Rs 45,000 crore in May 2021. While Arbitrage Funds saw a net inflow of Rs 4,520 crore in the same month.
Arbitrage Funds also offer a tax advantage over other short-term avenues like Liquid Funds of Bank Deposits. Arbitrage Funds are classified as Equity Funds, hence the short-term gains are taxed at 15 percent while gains accruing after one year of holding attract a tax of just 10 percent, that too for a gain of more than Rs 1 lakh during a financial year. However, returns on Liquid Funds or Bank Interest Income is taxed at marginal tax rate for up to 3 years, which means investors in high tax bracket will pay much higher taxes on these options.
So Arbitrage Funds definitely are a great option for parking short-term funds as long as the market volatility continues!
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