Difference between arbitrage and equity funds

Mutual funds provide investors with diversified exposure to various assets. By pooling funds from different investors, these funds engage in the acquisition of stocks, bonds, and other securities, ensuring a broad investment spectrum.

However, with this wide variety of options comes a potential roadblock – investing choices can be complex, especially when comparing different fund types. Two popular investment options – arbitrage funds and equity funds – might sound similar, but they are inherently quite different.

Let's dissect their characteristics to identify the ideal vehicle for your investment journey.

Table of contents

1. Understanding arbitrage funds
2. Understanding equity funds
3. Equity arbitrage funds: A hybrid investment explained
4. Tax implications for arbitrage funds and equity funds
5. Differences between arbitrage and equity funds
6. Arbitrage Fund vs Equity Fund: Which is a Better Investment Option?
7. When to choose arbitrage funds, liquid funds, or equity arbitrage funds?

Understanding arbitrage funds

Arbitrage funds can be a suitable option for investors seeking to capitalise on volatile markets while managing risk. Although their returns tend to be modest, arbitrage funds rely heavily on market inefficiencies. These funds are categorised as equity-oriented hybrid funds and they exploit price differentials in various markets, mainly pricing mismatches between exchanges or disparities between spot and futures markets.

This approach contrasts with traditional investing, as the arbitrage fund manager invests in equities and also in equity derivatives when a definite opportunity for returns arises. In the absence of arbitrage opportunities, the fund shifts to short-term money market instruments and debt securities. Notably, the price differences involved are usually minimal, requiring multiple daily trades for a reasonable profit.

Bajaj Finserv Asset Management Limited offers the Bajaj Finserv Arbitrage Fund, an open-ended scheme strategically investing in arbitrage opportunities. The scheme aims to generate returns by capitalising on arbitrage possibilities in the cash and derivatives segments of equity markets, with a balanced investment in debt and money market instruments. The Nifty 50 Arbitrage Index (TRI) serves as the benchmark, indicating the relatively low-risk nature of the principal investment. The scheme is tailored for investors eyeing short-term income and potential gains from arbitrage opportunities. However, it is crucial for investors to consult a financial advisor before making any investment decisions.

Read Also: What is an arbitrage fund? Key features and taxation

Understanding equity funds

Equity funds are an integral part of the investment landscape. They invest your money directly in company stocks, seeking long-term capital appreciation through company growth and dividend pay-outs. Equity Funds cater to diverse risk appetites, offering options from aggressive growth focused on young, high-potential companies to balanced solutions combining relative stability of blue-chip with growth possibilities. While offering the potential for reasonable returns, they also carry higher risk due to market fluctuations and individual company performance.

For example, Bajaj Finserv Asset Management Limited offers the Bajaj Finserv Large and Mid Cap Fund, an open-ended equity scheme strategically investing in both large cap and mid cap stocks. The fund's objective is to foster long-term capital appreciation through a diversified portfolio of equity and equity-related securities, chiefly focusing on large and mid-cap stocks across various sectors. Benchmarked against Nifty Large Midcap 250 TRI, this product caters to investors seeking wealth creation over the long term. The fund provides both direct and regular plans. However, investors should be aware of the high risk associated with their principal.

Arbitrage funds: A hybrid investment explained

Arbitrage funds fall under the hybrid fund category and aim to benefit from price differences in the same security across the cash and derivatives markets. While these funds hold equity positions, they simultaneously hedge them using derivatives. This structure reduces their net equity exposure, which is why arbitrage funds may exhibit relatively lower volatility compared to traditional equity funds. However, their performance still depends on market conditions and the availability of arbitrage opportunities.

Key characteristics include:

• Equity exposure with hedging: The fund maintains equity positions but offsets them through corresponding futures, reducing directional market impact.
• Tax treatment: Since they maintain more than 65% allocation to equities (through arbitrage), they are taxed as equity-oriented funds. Short-term capital gains are taxed at 20% and long-term capital gains are taxed at 12.5%, with an exemption on gains of up to Rs. 1.25 lakh.
• Potential benefit: Arbitrage spreads may offer potential for short-term parking of funds, though spreads vary across market conditions.

Tax implications for arbitrage funds and equity funds

Arbitrage funds and equity funds both fall under the equity-oriented taxation framework as long as they maintain the minimum equity allocation required by SEBI.

Short-term capital gains (STCG) tax applies when units of equity funds or arbitrage funds are sold within 12 months. STCG on equity-oriented schemes is taxed at 20%.

Long-term capital gains (LTCG) tax applies when units are held for more than 12 months. LTCG above Rs 1.25 lakh in a financial year is taxed at 12.5%.

Note: Above rates exclude cess and surcharge.

Differences between arbitrage and equity funds

Here’s a look at some of the key differences between arbitrage funds vs equity funds:

Read Also: How investment horizons impact arbitrage funds

Arbitrage fund vs equity fund: Which is a better investment option?

Choosing between an arbitrage fund and an equity fund depends entirely on your individual financial goals, risk tolerance, and investment horizon. There's no single ‘better’ option as each caters to different investment needs.

Equity funds are considered high-risk investments. However, they also offer the potential for higher returns over the long term.

Arbitrage funds are considered to have a relatively lower risk profile compared to equity funds. However, they are not risk-free. Arbitrage funds typically offer lower potential returns compared to equity funds. Their returns are generally more stable but lower.

Investors with a long-term investment horizon (e.g., 5-10 years or more), a higher risk tolerance, and are seeking potentially higher returns generally prefer equity funds.

Investors with a shorter investment horizon (e.g., 1 year), a lower risk tolerance, and who are looking for relatively stable return potential may choose arbitrage funds.

When to choose arbitrage funds, liquid funds, or equity arbitrage funds?

Arbitrage funds may be considered when investors want equity taxation along with relative stability and lower volatility. They may suit investors seeking short-term deployment with limited directional equity exposure.

Liquid funds invest in short-maturity debt instruments. They too offer relative stability and may be suitable for short-term investments. They may be used for managing temporary cash needs, with a focus on liquidity and lower duration exposure.

Equity funds may be suitable for investors with a high risk appetite and a long-term horizon. These schemes invest predominantly in shares and may offer long-term growth potential. However, they may experience high volatility, especially in the short term.

Conclusion

Choosing between arbitrage and equity funds depends on your risk tolerance and investment timeline. Arbitrage funds offer lower risk and predictable returns for shorter-term objectives, while equity funds unlock the potential for higher returns but demand a longer horizon and tolerance for volatility. Understanding these distinct features and your own financial priorities empowers you to select the optimal route towards achieving your investment goals. Always remember to consult a financial advisor before zeroing in on any investment product.

FAQs:

What is the main difference between arbitrage funds and equity funds?

Arbitrage funds capitalise on pricing gaps in securities across different markets, while equity funds invest in company stocks for long-term growth. This is the key difference between arbitrage and equity funds.

Which type of fund is more suitable for short-term investments?

Arbitrage funds are suitable for short-term financial goals, while equity funds, due to their inherent volatility, are better for a long-term investment horizon.

Are arbitrage funds less risky than equity funds?

Arbitrage funds exhibit lower risk due to their strategy, while equity funds involve higher market and company-specific risks. This is a key consideration when comparing arbitrage vs equity.

How do arbitrage funds generate returns compared to equity funds?

Equity funds generate returns through the potential appreciation in the value of stocks in the portfolio, among other factors. Arbitrage funds, on the other hand, profit from price discrepancies of the same asset across different markets or exchanges. They seek to capitalise on brief inefficiencies and fluctuations rather than the potential long-term growth of underlying assets.

Can I invest in both arbitrage and equity funds simultaneously?

Yes, investing in both arbitrage and equity funds can be a part of a diversified approach. Equity funds offer potential for long-term growth, while arbitrage funds can provide relative stability and lower risk. Moreover, equity funds are more suitable for long-term goals, while arbitrage funds can suit short-term goals. The specific allocation depends on your risk tolerance and financial goals.

Is it good to invest in arbitrage funds?

The suitability of arbitrage funds for an investor depends on their investment objectives and risk profile. If the investor has a long horizon or is seeking long-term capital appreciation, equity funds may be more suitable. If they have a short horizon or are seeking lower volatility, arbitrage funds may be suitable.

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