Under the equity umbrella, the standard mutual fund categories are large-cap, diversified, mid-cap and small-cap funds, and balanced funds. These funds are suited for all investors, depending on their risk appetite, and make for good long-term investments. Apart from these, there are niche fund categories that suit certain purposes only. They are not uniformly investible by all investors. We’re covering two of these in this post – arbitrage funds and equity savings funds.
The arbitrage strategy
Both these categories have one thing in common. These funds aim at reducing the volatility in returns through arbitrage. Arbitrage involves taking advantage of price differentials of the same security in different markets. 
Arbitrage would see this security bought in one market at a lower price and sold in another at a higher price. In equity, this pricing differential is usually between the spot and the derivatives market.
What funds do is to take opposite positions in each market. They could take a buy position in the spot market and sell position in the futures market. They could take offsetting positions on index futures. Funds look to make profits through such mispricing and offsetting positions.
What this also does is to hedge or counter the equity risk. Since funds are actively taking opposite positions, the equity exposure of the portfolio is covered by the derivative position. If a stock the fund holds falls, the fund has already taken a sell position at a higher price in the derivatives market, preventing portfolio returns from dipping. By taking such derivative strategies, funds neutralize market risk. A fully hedged portfolio will have no equity risk.
Arbitrage or mispricing opportunities are abundant in volatile markets. In a market that is heading in only one direction, either up or down, arbitrage opportunities dry up. Where funds do not find arbitrage opportunities, they invest in short-term debt securities to keep equity risk down.
Arbitrage funds
What they are: The extent to which the portfolio has an arbitrage exposure defines the type of fund it is. Pure or true arbitrage funds aim at being market-neutral or zero equity risk. Arbitrage funds take offsetting positions on their entire equity portfolio and leave no, or very small, portions of the portfolio unhedged or open. Note that funds cannot take short positions. There are further checks in terms of limits on derivative positions.
As a result, the volatility of equity markets is neutralised in arbitrage funds and they will not see the steep and frequent falls and rises that equity funds do. At the same time, arbitrage funds will not deliver equity-like returns. Returns cannot be high because any price gain in stocks held is capped by the opposite position taken through derivatives. Arbitrage funds only seek at delivering returns higher than short-term debt. In times of low arbitrage opportunities, their returns get hit and can be on par with liquid or ultrashort-term funds.
Taxation: Current tax laws allow derivative exposure to be counted as equity. Therefore, arbitrage funds are equity funds. Gains on holding for more than one year are tax-free and gains on shorter holding are taxed at 15%. Dividends are also tax-free.
Suitability: Arbitrage funds are not meant for long-term portfolios as they do not provide equity-like returns. These funds are useful for investors in higher tax brackets to park short-term money and gain from the tax efficiency. Arbitrage funds are not a substitute for liquid funds. Funds have showed an average 35% occurrence of 1-day losses, based on their daily rolling returns since inception. Liquid funds do not deliver one-day losses barring extreme circumstances. Remember, arbitrage funds are not really debt funds, but very low-risk equity funds.
Equity savings funds
What they are: These funds are an amalgam of balanced funds and arbitrage funds. They have a portion of their portfolio parked in debt and the remaining in equity, like balanced funds. In their equity holding, they put some in arbitrage, like arbitrage funds. However, the equity portion need not be hedged completely. These funds leave a portion of the portfolio unhedged based on their reading of the market conditions. If they feel that markets can move higher, they may have a higher open position to maximise gains.
Equity savings funds, therefore, are lower volatile and lower risk (and lower-returning as well) than balanced funds. They are also higher risk than arbitrage funds. Funds ensure, however, that the equity portion including the derivative portion is always above the 65% mark. This gives it an equity orientation from a tax perspective based on current tax laws.
Taxation: Gains on holding for more than one year are tax-free and gains on shorter holding are taxed at 15%. Dividends are also tax-free.
Suitability: These funds are suitable for conservative investors with a 1-3 year perspective, who do not want balanced funds. They are not suitable for long-term holdings because the hedged portion of the equity will lower returns. Balanced funds would be able to capitalise on equity markets adequately, which makes them suitable for long-term portfolios.
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I lost the article somewhere right at the beginning. How come say an Infosys stock exist in 2 markets at once (spot,derivatives etc.)? And the arbitrage fund takes opposite positions to what? In other words, what is the default position of the spot and futures market being talked about? Maybe a link explaining equity market structures should be given as precursor reading instead of assuming the reader is aware of these details.
Hello,
A derivative is an instrument which derives its value based on a stock or an index. So a Nifty option or Nifty future will see its value influenced by the actual (and expected) movement of the Nifty 50 index, or an Infosys future will derive its value from the Infosys stock. The spot or cash market is the one you will be familiar with – where you buy and sell your stocks normally. The derivative market ultimately gets its value from the spot market. So a fund can buy a stock in the spot market and sell it in the derivative market – thus taking opposite positions and being in two markets at once.
Thanks,
Bhavana
I lost the article somewhere right at the beginning. How come say an Infosys stock exist in 2 markets at once (spot,derivatives etc.)? And the arbitrage fund takes opposite positions to what? In other words, what is the default position of the spot and futures market being talked about? Maybe a link explaining equity market structures should be given as precursor reading instead of assuming the reader is aware of these details.
Hello,
A derivative is an instrument which derives its value based on a stock or an index. So a Nifty option or Nifty future will see its value influenced by the actual (and expected) movement of the Nifty 50 index, or an Infosys future will derive its value from the Infosys stock. The spot or cash market is the one you will be familiar with – where you buy and sell your stocks normally. The derivative market ultimately gets its value from the spot market. So a fund can buy a stock in the spot market and sell it in the derivative market – thus taking opposite positions and being in two markets at once.
Thanks,
Bhavana