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As you might know, arbitrage funds make profits or hedge risks from buy-and-sell opportunities in the cash and the derivatives market. Whereas equity savings funds invest in equity, arbitrage and debt. They are allowed to invest a minimum of 65 per cent in equities. This will include arbitrage positions. They have a minimum of 10 per cent in debt too.

So, arbitrage funds and equity savings funds have only one thing in common. Both of them aim at reducing the volatility in returns using arbitrage. Now, what is arbitrage? Arbitrage is taking advantage of price differentials of the same stock in different markets. So, the stock will be bought in one market at a lower price and sold in another market at a higher price. Which markets are they? These are the cash and the derivatives markets.

Funds take opposite positions in each of the market. For instance, they may take a buy position in the spot market and sell position in the derivatives market to make profits or hedge or counter the equity risk. Essentially, the equity exposure of the fund’s portfolio is covered by the derivatives position. How does this help? Let’s say the stock the fund has purchased falls. The fund has already taken a sell position at a higher price in the derivatives market. This will prevent the fund’s portfolio returns from dipping.

Arbitrage opportunities are abundant only in volatile markets. If funds do not find arbitrage opportunities, they invest in short-term debt securities to lower equity risks. So, there ends the similarity between arbitrage and equity savings funds. Let’s look at the differences.

The differences

Portfolio

Arbitrage funds take offsetting positions on their entire equity portfolio in the derivatives markets. They leave a very small portion of their portfolio unhedged or open. As a result, the volatility of returns is neutralised in arbitrage funds and they will not see steep and frequent falls or rises.

Equity savings funds are an amalgamation of balanced funds and arbitrage funds. They have a portion of their portfolio in debt and the remaining in equity and some part of their equity will have arbitrage. Note that the equity portion will not be hedged completely. These funds leave a portion of their portfolio unhedged. This can be more or less based on their market research. If they feel that markets can move higher, they could decide to have a higher open position to maximise the gains.

There are equity savings funds that hold direct equity. They can actually hold significant amounts of direct equity. This means that they can have a net long equity exposure.  In simple words, the extent to which they can buy stocks can be more than the extent to which they short the stocks. There are funds that are allowed to invest in foreign stocks. So, the risks are higher for equity savings funds.

Returns

Arbitrage funds will not deliver returns that match equity funds. This is because any price gain in stocks they hold will be limited by the opposite position they take using derivatives. Arbitrage funds usually provide returns that are slightly higher than short-term debt funds. In times of low arbitrage opportunities, their returns might get hit and they could fall to be on par with liquid or ultrashort-term funds.

Equity savings funds tend to provide higher returns in the short term because of their equity holdings. These returns tend to get averaged out in the long run. For instance, the one year return of ICICI Prudential Savings Fund is about 12% while the five year return is 7%.      

Taxation

As per the present tax laws, fund houses are allowed to count derivative exposure as equity. So, arbitrage funds and equity savings funds are considered as equity funds. So, any gains on holdings of more than one year are tax-free up to Rs. 1 lakh. Gains of over Rs. 1 lakh will be taxed at 10%.  Short-term capital gains, when the fund is held for less than a year, are taxed at 15%.

Suitability

Arbitrage funds can be considered by those in the higher tax brackets to park their short-term money. Note that arbitrage funds are not a substitute for liquid funds and might have higher risks than the latter. So, remember that arbitrage funds are low risk equity funds and not debt funds.

If you have a time horizon of one to three years and don’t want to look at balanced funds, you can consider equity savings funds. Note that it is best to remain invested in these funds for lesser number of years rather than for the long haul as the hedged portion of the equity will lower returns. Balanced funds capitalise on equity markets adequately and are suitable for long-term portfolios.

Note that under the equity funds umbrella, the standard mutual fund categories are many. This includes large-cap, diversified, mid-cap funds, small-cap funds, multi-cap funds, balanced funds among others. These funds are suited for all investors, depending on their risk appetite and are good long-term investments. However, arbitrage and equity savings funds are not for everyone and some research is needed if you want to invest in these funds.