In today’s uncertain world, many conservative investors including retirees are on the lookout for an investment option that offers them stable monthly cashflows, reasonable returns, little to no risk, and tax efficiency. While Fixed Deposits are a go to option for many, there is another lesser-known investment option that can work surprisingly well for those seeking monthly income with stability – Arbitrage Funds.
In this blog today, we understand Arbitrage Funds, how they work, what makes them different, and how you can utilise them to generate a steady post tax income.
What are Arbitrage Funds?
Arbitrage Funds are a category of Hybrid Mutual Funds having majority of exposure to equity related instruments. But stable returns through equity instruments? Sounds bizarre, right? Arbitrage Funds work on the concept of generating Arbitrage Returns which involves looking out for opportunities of price difference of same underlying asset and to generate returns by exploiting the opportunity. Let us help you understand this concept using a simple example.
Let’s say Coconuts cost ₹60 per unit in a nearby market while they cost ₹50 in a distant market. You come across this price difference and plan to exploit this opportunity to earn profits by buying coconuts from the distant market in bulk while selling them in the nearby market to pocket the difference. There will be other costs like transportation cost but the impact on them will be little on your net profit as you buy coconuts in quantities. You only buy when you have someone who has agreed to buy from you which reduces your risk to absolutely nothing.
This is exactly how Arbitrage Funds generate returns using Equity instruments. They explore opportunities of price difference in cash as well as derivative markets and exploit them till the profits earned equal the cost to execute such trades. The biggest advantage here is that these funds are market neutral i.e. they do not rely on market direction to generate returns and hence they can offer returns that are stable.
How are Arbitrage Funds different from other Funds?
Unlike equity funds that aim to grow wealth through long term investments in equity instruments, arbitrage funds do not chase high returns. They aim to earn a steady income by taking minimal risk by taking short term positions and consistently locking in small profits. Debt Funds position themselves in short term or long term securities to generate returns. The risk that they face is interest risk, credit risk, and default risk. Arbitrage funds carry net zero risk as they maintain hedged positions. Let us compare them via a simple comparison.
| Features | Equity Funds | Debt Funds | Arbitrage Funds |
|---|---|---|---|
| Investment Risk | High – Very High | Moderate | Very Low |
| Return Potential | High | Moderate | Low – Moderate |
| Volatility | High | Moderate | Low |
Monthly Income via SWP in Arbitrage Funds
By investing in Arbitrage Funds, you can also create a Systematic Withdrawal Plan (SWP) and generate regular monthly cashflows just like getting interest payments through FDs. The only difference here is that you remain in control and you have the flexibility to increase / decrease the amount withdrawn. Here is how it works in Arbitrage Funds. You invest a fixed lump sum amount in the fund.
You setup a SWP to withdraw a fixed amount at regular intervals. If the amount you withdraw is less than the returns generated, the fund also grows slowly in the background, and compound with time. Let us take a few examples of how much you can withdraw comfortably while also maintaining similar fund value.
| Investment Amount | SWP Amount | Fixed Deposit Interest |
|---|---|---|
| ₹10,00,000 | ₹5,300 | ₹5,157 |
| ₹20,00,000 | ₹10,600 | ₹10,314 |
| ₹30,00,000 | ₹15,900 | ₹15,472 |
| ₹50,00,000 | ₹26,500 | ₹25,786 |
| ₹75,00,000 | ₹39,750 | ₹38,679 |
| ₹1,00,00,000 | ₹53,000 | ₹51,572 |
Source: Value Research, SBI, EduFund Internal Research
As you can observe, SWP through Arbitrage Funds may actually offer you slightly higher cashflow than Fixed Deposits while maintaining same Portfolio Value. In case you are okay to reduce your portfolio over a few years say for 20 years, you can withdraw even higher amounts.
Why Arbitrage Funds are attractive?
1. Stability of Returns:– Arbitrage Funds typically generate returns between 5%-7% per annum and usually a tad bit higher than Fixed Deposits. So not very high returns but more stable than equities and less volatile than debt funds during volatile interest rate cycles.
2. Low Risk Profile:– Arbitrage as a concept itself aims to generate returns by taking net zero risk. Arbitrage Funds as a result carry very low risk. So, while they invest in equity, they act like stable debt funds.
3. Better Post Tax Returns:- One of the biggest advantage of Arbitrage Funds is that they are stable like Debt Funds while they are taxed like Equity Funds. As a result, the net post tax returns are higher when compared to post tax returns in Fixed Deposits. This is because gains on Mutual Funds are taxed at 12.5% for LTCG and 20% for STCG while FD interest are taxed at slab rate of the investor. Also, when you withdraw through SWP, the tax impact is even lower as a major portion in early withdrawals is your actual capital.
Who should consider Arbitrage Funds?
Arbitrage Funds can be ideal for retirees or conservative investors who are looking to generate stable regular income with low risk, those who fall in higher tax brackets and want better post tax returns than FDs, and investors who do not want market volatility but want flexibility, liquidity and control.
Final Thoughts
Arbitrage Funds often go unnoticed by investors who are looking to generate a stable and tax efficient cashflow. The strategy does not make headlines because it does not look to generate high returns by taking risk and instead generate stable returns by taking net zero risk.
As the world markets including equity and debt gets volatile and unpredictable, arbitrage funds can be your go to option for safe and stable returns. Used properly, it can help you create a strong and stable cashflow through SWP so do consider taking a closer look on them.
Disclaimer: The data in this presentation are meant for general reading purpose only and are not meant to serve as a professional guide/investment advice for the readers. This presentation has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Whilst no action has been suggested or offered based upon the information provided herein, due care has been taken to endeavor that the facts are accurate and reasonable as on date. The information placed on the presentation is for informational purposes only and does not constitute as an offer to sell or buy a security.The Company reserves the right to make modifications and alterations to the content available on the presentation. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investment. The EduFund platform & the website is owned, operated and maintained by Helena Edtech Private Limited, a company incorporated under the laws of India. An affiliate of the Company, i.e. Edubillions Tech Private Limited is registered with AMFI as mutual fund distributor bearing the registration number ARN258733. Investment in securities market are subject to market risks, read all the related documents carefully before investing. The valuation of securities may increase or decrease depending on the factors affecting the securities market.
