How does an arbitrage fund work and should you invest in it?

In the dynamic world of investments, there's an intriguing option that has been gaining attention among investors - arbitrage mutual funds. These funds operate with a unique strategy that aims to capitalise on price differentials in various markets. But are arbitrage funds suitable for you? In this article, we'll look at the mechanics of how an arbitrage fund works and help you understand whether it's a worthy addition to your investment portfolio.

• Table of contents

1. What is an arbitrage fund?
2. How does an arbitrage fund work?
3. Features of arbitrage funds
4. Should you invest in an arbitrage fund?
5. FAQ

What is an arbitrage fund?

Arbitrage, in the financial context, refers to the practice of exploiting price imbalances of an asset in different markets. Arbitrage funds leverage this concept by simultaneously buying and selling assets, such as stocks or derivatives, to profit from price differentials. These funds usually focus on exploiting price gaps between the cash and futures segments of the equity market.

How does an arbitrage fund work?

Arbitrage funds follow an intricate strategy to generate potential returns. Let's break it down in simple terms. Imagine that a stock is trading at a slightly higher price in the futures market than in the cash market. An arbitrageur (a person who practises arbitrage) would buy the stock in the cash market and sell it in the futures market. This dual-sided transaction aims to capture the profit derived from the price difference while minimising exposure to market movements.

To grasp the inner workings of an arbitrage fund, let's consider into a more straightforward example. Imagine company ABC's stock is trading at Rs. 100 in the cash market, while its futures contract is priced at Rs. 105 due to expected future demand. Here's where the arbitrage comes into play. An astute arbitrageur spots this price difference and seizes the opportunity. They buy company ABC's stock for Rs. 100 in the cash market and simultaneously sell a futures contract for Rs. 105. This dual-action move ensures that they are both buying and selling the same asset at different prices in distinct markets.

Now, let's consider two possible scenarios:

Price convergence: As the contract's expiry date nears, the futures price aligns with the cash market price at Rs. 100. The arbitrageur closes their positions by selling the stock at Rs. 100 in the cash market and buying back the futures contract at Rs. 100. The profit, in this case, is the Rs. 5 price differential per stock sold.

Price divergence: Alternatively, if the futures price remains higher at expiry, say Rs. 110, the arbitrageur reverses the process. They buy the stock back at Rs. 110 in the futures market and simultaneously sell it for Rs. 100 in the cash market. In this scenario, the arbitrageur faces a loss of Rs. 10 per stock sale due to the persistent price gap.

In essence, an arbitrage fund engages in a series of such calculated transactions, aiming to capitalise on price discrepancies. This practice involves meticulous monitoring and quick execution, as the market is ever-changing. Through such strategic manoeuvres, arbitrage funds seek to generate returns while minimising exposure to market volatility.

Features of arbitrage funds

Arbitrage funds are often considered low-risk investments due to their hedged positions. By maintaining opposing positions in different markets, these funds mitigate the impact of market fluctuations. However, it's important to note that while the risk is lower compared to some other investment avenues, the potential returns might also be relatively lower.

Another appealing aspect of arbitrage funds is their tax efficiency. They are treated as equity funds for taxation purposes if they invest a major portion of their assets in equities. This translates to a better tax rate compared with debt funds, making them a suitable option for investors looking to optimise their tax liability.

Should you invest in an arbitrage fund?

Now comes the pivotal question: should you consider investing in an arbitrage fund? The answer isn't a definitive “yes” or “no”, but rather a consideration of your financial goals and risk appetite.

First and foremost, evaluate how an arbitrage fund aligns with your investment goals. These funds are ideal for investors seeking relatively steady, low risk returns over a medium to long-term horizon.

If your primary aim is wealth generation through mutual funds while reducing impact on capital, arbitrage funds could be a worthy contender. As with any investment decision, diversification plays a crucial role. Arbitrage funds can complement your existing investment portfolio by adding a layer of diversification. Arbitrage funds can potentially provide returns that are not directly correlated with traditional equity or debt investments.

However, it's important to remember that all investments carry a degree of risk. Thus, it's highly recommended to consult a financial advisor or distributor before making any investment decisions. A seasoned professional can evaluate your individual financial situation, risk tolerance, and investment goals to provide personalised guidance.

In conclusion, arbitrage funds offer an intriguing avenue for potential wealth generation through mutual funds. Their distinctive strategy of capitalising on price differentials sets them apart in the investment landscape. However, before diving in, it's essential to weigh the potential benefits against your own financial objectives and risk tolerance.

Remember, the world of investments is complex and ever-evolving. Just as a chess player calculates multiple moves ahead, investors need to anticipate the implications of their choices. By making informed decisions, seeking professional advice, and staying attuned to market dynamics, you can harness the potential of arbitrage funds while on the path to financial success.

FAQs:

How does an arbitrage fund generate returns?

Arbitrage funds exploit price differences between cash and futures markets to generate returns with relatively lower risk.

When is investing in an arbitrage fund suitable?

Investors seeking low-risk options with potentially reasonable returns than traditional debt funds may consider arbitrage funds, especially during volatile markets.

What are the risks associated with arbitrage funds?

While they are lower risk than pure equity funds, arbitrage funds are still be subject to market and liquidity risks .

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.