What is an arbitrage fund?

Investments in arbitrage funds have seen an upward trend in recent years. More and more investors are getting drawn towards these funds, especially during periods of market volatility. In this article, we will explore what arbitrage funds are, how they work, why they have gained popularity, and ultimately, whether they are a viable investment option amidst market turbulence.

• Table of contents

• What are arbitrage funds?
• How do arbitrage mutual funds work?
• Who should invest in arbitrage mutual funds?
• Factors to consider before investing in arbitrage mutual funds in India
• The key benefit of investing in arbitrage funds
• But where does market timing come in?
• How to benefit market timing in arbitrage fund?
• Why arbitrage funds became popular?
• What is the risk in an arbitrage fund?
• Taxation on Arbitrage Fund
• How to invest in Arbitrage Fund

What are arbitrage funds?

Arbitrage funds are hybrid funds, which means they can invest in both equity and debt. However, most arbitrage funds are equity-oriented hybrid mutual funds as they have more than 65% exposure in the equity market. Arbitrage funds can be a preferred option for investors with a low-risk appetite. Now that you know about the arbitrage mutual funds meaning, let’s see how these funds can help you make money.

Arbitrage funds take advantage of the differences in securities prices between markets. These price variations may be the result of a number of things, including market inefficiencies, supply-demand mismatches, and variations in trade volume.

How do arbitrage mutual funds work?

Arbitrage funds utilize the pricing disparity of securities across markets. These price differences can occur due to various factors, such as supply-demand imbalances, market inefficiencies, or differences in trading volumes.

For example, if the stock of a company is trading at different prices on different exchanges, the arbitrage fund manager can buy low on one exchange and sell high on another exchange for a profit. However, the margins are extremely low, and the fund manager will have to make several trades to achieve respectable gains.

Let’s assume that a unit share of a company is trading at Rs.100 while the futures market values it at Rs. 100.5. In such a scenario, the fund manager can buy 10 shares at the current market price (Rs. 100) and make a contract to sell the same in the futures market at Rs.100.5. The result would be a risk-free profit of Rs. 5.

Who should invest in arbitrage mutual funds?

• Investors with a low-risk appetite: Arbitrage funds can be a suitable option for investors who wish to earn a profit without taking much risk. Moreover, investors in arbitrage funds can make gains even when the markets are extremely volatile.
• Investors with a short to medium horizon: Arbitrage funds generate relatively stable returns over a short and medium horizon, making them preferred for investors looking for indicative investment horizon of 3 months and above.
• Investors looking for Systematic Transfer Plan (STP): Investors can use this fund as a source scheme for doing Systematic Transfer Plan (STP) to diversified equity funds.

Factors to consider before investing in arbitrage mutual funds in India

Before plunging into an investment in arbitrage funds, here are the things you need to be aware of:

Investment objective: Understand your investment objectives, whether they are capital preservation, moderate growth, or tax efficiency.

Fund selection: Choose a fund with a relatively stable track record, experienced fund managers, and a low expense ratio. Research various funds to find the one that aligns with your objectives.

• Risk: While there is no counterparty risk associated with arbitrage funds, their increasing popularity reduces the number of arbitrage opportunities available and erodes the price differential between markets.
• Returns: As per an article by The Economic Times, dated 13th March 2023, arbitrage funds have made a strong comeback after delivering mediocre returns in the past two years.
• Taxes: Arbitrage funds are treated as equity oriented mutual funds for the purpose of taxation. STCG (if you stay invested for less than 1 year) are taxed at 15%, while LTCG (if you stay invested for more than 1 year) over Rs.1 lakh are taxed at 10% (without indexation). It’s recommended to consult your tax consultant for better understanding of the same.

The key benefit of investing in arbitrage funds

• Low risk: Since these funds rely on small price differentials for generating a profit, they are relatively stable compared with equity funds. On the other hand, when arbitrage opportunities are few, the fund manager can invest certain portion of scheme assets in high-credit quality debt with an aim to ensure a reasonable return on the capital.

To sum it up, arbitrage funds can prove to be a good investment instrument for risk-averse investors. These funds work when the markets are volatile and generate reasonable return. So, if you wish to achieve your short-term investment goals with minimum risk, you can consider investing in arbitrage funds.

But where does market timing come in?

Here's the key: arbitrage funds don't rely on predicting future trends. Instead, they exploit current, temporary price discrepancies that are almost guaranteed to disappear. Think of it like finding two identical, yet mispriced items on different shelves of the same store. Arbitrage funds identify these mismatches and capitalise on them before they vanish, essentially playing a game of market timing without the crystal ball.

How to benefit market timing in arbitrage fund?

Choose a fund with a proven track record: Seek a fund with experience in identifying and utilizing arbitrage opportunities, a consistent performance history, and a skilled management team.

Remember, it's not risk-free: While relatively stable than stock picking, unexpected events like regulatory changes or technical glitches can affect the fund's performance.

Think long-term: These funds offer steady, low-risk returns, not overnight riches. They can be a good addition to a diversified portfolio for patient investors seeking potential stability and growth.

Seek professional advice: A financial advisor can help you determine if arbitrage funds align with your specific risk tolerance and financial goals.

Why arbitrage funds became popular?

The popularity of arbitrage funds can be attributed to several factors that make them stand out in the investment landscape.

Relatively steady returns: Firstly, their ability to generate relatively steady returns, regardless of the market's overall movement, appeals to many investors seeking some stability from equity investing.

Level of comfort: Additionally, their relatively low-risk nature provides a certain level of comfort during periods of heightened market volatility.

Hedged positions: Unlike other investment options that can be adversely affected by sharp market downturns, arbitrage funds tend to maintain their value due to their hedged positions.

What is the risk in an arbitrage fund?

While arbitrage mutual funds are generally considered low risk, they are not entirely devoid of potential drawbacks. One key risk factor is the market risk that arises during periods of extreme market volatility.

Market risk: Certain events such as sudden regulatory changes or unexpected macroeconomic shifts can create unforeseen price disparities that may affect the fund's returns. Additionally, since arbitrage opportunities are time-sensitive, any delays in executing trades could lead to reduced profitability or missed opportunities.

Liquidity risk: Investors should also be aware of liquidity risk. While arbitrage funds are relatively liquid compared to traditional closed-end funds, they may still face redemption pressures during market downturns, leading to potential liquidity issues. This could force the fund manager to sell positions at unfavorable prices, impacting overall returns.

Taxation on Arbitrage Fund

Arbitrage funds are taxed as equity-oriented funds because they invest at least 65% of their assets in equity and equity-related instruments. This means they are subject to the same tax rules as equity mutual funds.

Short-Term Capital Gains (STCG): If you sell your arbitrage fund units within 12 months (1 year) of purchase, the gains are considered short-term capital gains. STCG on arbitrage funds is taxed at 20%.

Long-Term Capital Gains (LTCG): If you hold your arbitrage fund units for more than 12 months, the gains are considered long-term capital gains. LTCG on arbitrage funds is taxed at 12.5% without indexation. However, there's an exemption of up to ₹1.25 lakh in a financial year. This means that if your long-term capital gains from arbitrage funds are within ₹1.25 lakh, they are tax-free.

How to invest in Arbitrage Fund

Investing in an Arbitrage Fund involves a similar process to investing in other mutual funds. Here's a step-by-step guide:

Complete KYC (Know Your Customer): KYC is a mandatory process for all investors in India. If you are not KYC compliant, you will need to complete the KYC process before investing. You can complete KYC online or offline through a SEBI-registered intermediary.

Choose an investment platform:

You can invest in Arbitrage Funds through various platforms:

Directly through the AMC: You can visit the Asset Management Company's (AMC) website or their branch office to invest directly. This may sometimes offer lower expense ratios as you are investing directly with the fund house.

Through online platforms: Several online platforms and mobile apps allow you to invest in mutual funds. These platforms often provide a convenient way to compare different funds and manage your investments.

Through a financial advisor: A financial advisor can guide you through the investment process and help you choose the right fund based on your financial goals and risk tolerance.

Open an investment account (if needed): If you are investing through an online platform or directly with the AMC, you might need to open an investment account. This usually involves providing your personal and financial details.

Select the fund and investment option: Choose the Arbitrage Fund you want to invest in. Decide between a lumpsum investment or a Systematic Investment Plan (SIP). A SIP involves investing a fixed amount regularly, which can be beneficial for rupee cost averaging.

Make the investment: Once you have chosen the fund and investment option, you can make the payment through various methods, such as net banking, debit card, or UPI.

FAQs

How risky is an arbitrage fund?

Arbitrage funds are relatively low-risk investment options as they aim to make gains from the price differences between the cash and futures market of securities. However, as with any other investment, there is always some degree of risk involved, and investors should thoroughly consider their risk tolerance and investment objectives before investing in arbitrage funds.

Are arbitrage funds better than Fixed Deposits (FDs)?

Arbitrage funds and FDs are two different investment options with different risk and return profiles. The choice between arbitrage funds and FDs will depend on your risk appetite, investment goals, and personal preferences.

Can arbitrage funds give negative returns?

Though rare, arbitrage fund returns can be negative, specifically during periods of market volatility or unexpected events that disrupt market stability. However, the risk of negative returns in arbitrage funds is generally considered lower compared to other equity-based investments.

Is it good to invest in arbitrage funds?

Arbitrage funds are considered relatively stable option than other equity investments. However, like any investment, there is a degree of risk involved, and investors should consider their investment goals and risk appetite before investing in arbitrage funds.

What are the advantages of arbitrage funds?

Arbitrage funds offer relatively low-risk returns, suitable for short-to-medium term investment goals with less stock market risk. They are comparable to pure debt funds and can provide reasonable returns on surplus cash.

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.