There are over 1,000 mutual fund (MF) schemes by over 40 different MF companies. Such a choice can be especially confusing for new investors, such as Gen Z investors, who are new to the world of investing. One of the categories of funds to consider is the hedge fund, as they are only low risk and benefit from equity taxation.

What are equity arbitrage funds?

Equity arbitrage funds are the only investment funds that carry the low-risk label despite being equity funds. As the name suggests, arbitrage is a practice in which a person takes advantage of the price difference of the same securities in two different markets, for example, the spot market, the futures market or two exchanges. These funds essentially use this “mispricing” to buy and trade securities at different prices in different markets.

Equity arbitrage funds aim to provide risk-free returns by playing on the difference in equity prices in different markets and/or segments, for example, BSE versus the national stock exchange, or the spot market (spot segment) versus the futures market (derivatives segment). “Simultaneous buy and sell positions are created in an underlying stock or its derivative in different market segments. This ensures that positions are 100% hedged to generate risk-free profit,” says Piyush Nagda, head of investment products at brokerage and financial services firm Prabhudas Lilladher.

How it works?

Let’s take an example. Suppose the share price of ABCD company today is Rs 2,418 in the spot segment and Rs 2,428 in the February futures segment. The fund manager of the equity fund will buy ABCD shares in cash and sell in the futures segment keeping the same amount in both trades. This difference of Rs10 is the gross profit of this trade. This is how equity arbitrage funds achieve a lower risk profile. Since the position trade is fully hedged against any unforeseen price fluctuations, there is virtually no loss to suffer.

“Cash and carry arbitrage, that is to say spot versus future, is one of the most used strategies by arbitrage funds. Suppose the price of a share of Company X in the spot (spot market) is Rs 500 and the price of its futures contracts in the derivatives market (futures and options segment) is Rs 503 You can lock in Rs 3 earnings per share by simultaneously buying in the spot market and selling in the derivatives market,” says Nagda. “The profit due to the price difference on the trading day will accrue regardless of the movement of the stock price because at the expiration of the futures contract (the last Thursday of the month), the spot price and the future prices will converge and become identical,” he adds. .

If the fund manager finds no arbitrage opportunities, unused cash is invested in very short-term securities such as overnight money market or overnight securities to generate interest income. This is why equity arbitrage funds have high cash flow compared to other types of equity funds.

How are these funds taxed?

Equity arbitrage funds are assimilated to liquid funds while benefiting from equity taxation rules. If you sell your hedge fund shares with gains within 12 months, short-term capital gains tax will apply. Currently, the short-term capital gains tax rate on equity funds is 15%. But in case of debt funds, it is according to your tax slab. “In the case of debt funds, the short-term capital gain is triggered upon sale/repayment within three years,” says Nagda. So, arbitrage equity funds also offer an advantage in terms of when you sell your shares.

To find out more about the taxation of your investments, click here

Things to watch out for

Investors should note that equity arbitrage fund returns are lower; similar to what cash funds do, not what equity funds do. Moreover, these funds operate on the basis of arbitrage opportunities. Although this has not happened yet, but in the long term, as the assets of these funds increase, there may be fewer arbitrage opportunities.