A beginner's guide to investing in arbitrage funds

Arbitrage occurs when the same security trades at different prices across multiple markets. Investors can profit from these price discrepancies by buying the asset in one market and simultaneously selling it in another. This strategy takes advantage of inefficient pricing to lock in small, relatively low-risk gains.

While professional traders can pursue arbitrage plays, arbitrage mutual funds make this strategy accessible even for everyday investors. Arbitrage mutual funds comprise portfolios that are actively managed to identify and exploit pricing anomalies between related securities.

Here is a complete guide for arbitrage fund investment for beginners.

• Table of contents

1. What is an arbitrage fund?
2. How arbitrage funds work
3. Why consider arbitrage funds: Key benefits and advantages
4. Who should invest in arbitrage funds?
5. Factors to consider before investing in arbitrage mutual funds in India
6. Taxation of arbitrage funds

What is an arbitrage fund?

Arbitrage involves the simultaneous purchase and sale of securities in different markets to ensure small, relatively low risk returns. Thus, arbitrage trading requires real-time monitoring of markets and swift trade execution.

Arbitrage funds fall under the category of hybrid mutual funds. Arbitrage funds are investment vehicles that seek to generate returns by systematically exploiting pricing anomalies and inefficiencies. Fund managers continuously analyze markets and execute trades when arbitrage opportunities arise. For instance, a fund manager can simultaneously buy a relatively undervalued security while ‘shorting’ or selling its overvalued equivalent in another market. The price differential represents a low-risk gain once the positions are closed.

Read Also: Need to know about arbitrage funds and liquid funds

How arbitrage funds work

Rather than betting on market direction, arbitrage mutual funds rely on the convergence of temporary price discrepancies. By aggregating many minor spreads across a high volume of trades, arbitrage funds can generate returns unrelated to broader market volatility.

While this strategy may not outperform benchmark indices, it can potentially enhance portfolio diversification and risk-adjusted returns. For passive investors, arbitrage funds can efficiently capitalize on pricing oddities and inefficiencies in our complex global securities markets.

Why consider arbitrage funds: Key benefits and advantages

Arbitrage funds offer three main advantages that make them an attractive investment vehicle for many investors.

Relatively low risk returns

Arbitrage mutual funds seek to provide the opportunity for potentially reasonable, low risk returns that are largely uncorrelated with broader market conditions. Because arbitrage trades exploit temporary pricing discrepancies between related securities, the strategy does not rely on market direction or speculation.

Diversification

Arbitrage funds tend to provide returns that demonstrate a low correlation to traditional asset classes like stocks and bonds. This helps reduce the overall portfolio volatility.

Accessibility

Arbitrage trading requires real-time trade execution and constant monitoring of pricing discrepancies across markets. The fund structure allows even retail investors to tap into the expertise of professional arbitrage traders. Hence, it democratizes a proven strategy once reserved for large financial institutions.

Alpha in arbitrage funds

Arbitrage funds aim to returns by exploiting pricing inefficiencies between securities. Arbitrage captures the price differential as a risk-free gain when the prices ultimately converge. While each trade only yields a small spread, aggregating many arbitrage opportunities over time can lead to incremental outperformance.

Who should invest in arbitrage funds?

Arbitrage funds could suit the portfolios of the below set of investors:

• Risk-averse investors looking to their park surplus funds.
• Investors who want to take advantage of equity taxation.
• Investors looking for alternatives to overnight funds and savings bank deposits.

Read Also: How does an arbitrage fund leverage market timing

Factors to consider before investing in arbitrage mutual funds in India

Equity classification: Since at least 65% of assets are allocated to equities and related instruments for tax benefits, arbitrage funds are classified as equity-oriented. However, their actual direct equity exposure may be lower.

Return expectations: Arbitrage funds generally aim to provide returns comparable to or slightly above short-term debt options like liquid funds or fixed deposits. High returns should not be expected.

Past performance: Reviewing historical data can provide insights into how these funds have performed under different market conditions, though past performance does not predict future results.

Relatively lower risk: By locking in gains through simultaneous buy-sell transactions, arbitrage funds tend to be less risky than pure equity funds. However, they still carry risks.

Market volatility: Increased volatility can create arbitrage opportunities but may also make execution challenging in extreme conditions.

Expense ratio: Due to the active management needed to identify and act on arbitrage opportunities, these funds generally have higher expense ratios than liquid funds. It is important to assess how this impacts potential returns.

Taxation of arbitrage funds

Arbitrage funds are classified as equity-oriented funds for tax purposes, despite their relatively lower risk profile. This is because they invest at least 65% of their assets in equity and related instruments.
Short-term capital gains (holding period under one year) are taxed at 20%, while long-term capital gains (holding period of at least one year) are taxed at 12.5% on gains exceeding Rs. 1.25 lakh in a financial year without indexation benefit.

Conclusion

The key to choosing arbitrage funds is to first understand that arbitrage is not without risks. The pricing anomalies that arbitrage trades exploit may fail to converge as expected, resulting in potential losses. Ultimately, whether arbitrage mutual funds belong in your portfolio depends on your specific investment objectives, time horizon, and risk tolerance. Hence, make sure you consider your goals, and risk appetite and make use of this arbitrage fund beginners guide before investing. It is also advisable to consult a financial advisor before making any investment decisions. You can consider investing in Bajaj Finserv Arbitrage Fund by Bajaj Finserv Mutual Fund.

FAQ

What is an arbitrage fund?

An arbitrage fund is a type of mutual fund that aims to exploit price differentials between the cash and derivatives markets. It does this by simultaneously buying and selling assets to capture risk-free gains.

How does an arbitrage fund minimize risk?

These funds are designed to have a low-risk profile because they capitalize on price differences in highly liquid and correlated securities. They are considered less risky than pure equity funds.

Who should consider investing in arbitrage funds?

Investors seeking relatively low volatility and a short investment horizon may find arbitrage funds suitable.

What are the disadvantages of arbitrage funds?

Arbitrage funds, while potentially less risky than pure equity funds, have some drawbacks. Returns are often limited, as they depend on the availability of arbitrage opportunities, which can be inconsistent. Lower market volatility can reduce these opportunities, impacting returns. Additionally, changes in regulations or market conditions can negatively affect arbitrage strategies.

Is it suitable to invest in arbitrage funds?

No mutual fund investment is completely risk-free. While arbitrage funds are generally considered less risky than equity funds, they still face market fluctuations. Their returns rely on effective arbitrage strategies, which can be influenced by market conditions. Investors should evaluate their risk tolerance before investing.

Is an arbitrage fund tax-free?

No, arbitrage funds are not tax-free. They are taxed as equity funds, even though their exposure to equity risk is relatively lower.

What is the rate of return of an arbitrage fund?

There is no fixed rate of return. Arbitrage funds aim to generate returns higher than liquid funds but lower than equity funds. Actual returns depend on market conditions and the fund manager's ability to identify and execute arbitrage opportunities, which fluctuate with market volatility.

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.