What is an 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 is given below:

• 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.

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.