Mutual funds (for example, arbitrage funds) serve as a go-to investment avenue that has gained enormous amounts of popularity in the past few years. This is because they provide investors with exposure to a number of assets. Investors’ money is pooled together and used to purchase bonds, stocks, and other securities. These funds are managed by money managers who strive to accrue gains for their investors.
Arbitrage funds are mutual funds that seek to earn profits by taking advantage of price differences between the cash (or spot) market and the derivatives market. This is achieved through simultaneous buying and selling transactions in both markets. Arbitrage funds capitalise on the price difference of equity shares between two different markets — to gain maximum returns.
Arbitrage funds draw profits from varying prices in different markets. For instance, they may buy stock in a cash market and proceed to sell the interest from it in the futures market. It's because the most pressing forms of arbitrage transpire between these two markets, regardless of how minute they may be. Owing to this fact, arbitrage funds strive to maximise the number of trades they make each year to draw significant returns.
Now that you know the meaning of an arbitrage fund, let's examine two situations that it operates within:
Consider company MNO's shares which trade at Rs. 500 in the cash market and Rs. 650 in the futures market. An arbitrage fund's manager can purchase shares from the cash market and create a futures contract to sell them for Rs. 650.
Once the month closes, they can sell the shares within the futures market for a gain of Rs 150 per share (minus the transaction fees) without incurring any risks.
Assume that Company ABC's stock is being sold for a price of Rs. 1,500 per share on the Calcutta Stock Exchange (or CSE) and at Rs. 1,250 on the Metropolitan Stock Exchange of India (or MSE). If an arbitrage fund's manager identifies this gap, they can purchase these shares from the MSE and sell them on the CSE.
It would permit them to draw in profits of Rs. 250 per share (minus the transaction fees) without incurring any risks.
Arbitrage funds generate profits via buy and sell opportunities linked to low risks within the cash and futures markets. If one were to compare their level of risk, they would equate to that of a pure debt fund. In fact, a number of arbitrage funds stay in line with Crisil BSE’s 0.23% Liquid Fund Index and use it as their benchmark.
Investors who wish to acquire some equity exposure but worry about the risk associated should consider arbitrage funds. These funds are best suited to risk-averse individuals who can be confident in storing their surplus funds in instances of persistent market fluctuations.
Investors do not experience risks of equity exposure as their fund manager is responsible for buying stocks in one market and simultaneously selling them in another. That said, the scenarios wherein this arises are limited, and the price difference is ordinarily minimal. Owing to this fact, the returns drawn are average.
Should you invest in an arbitrage mutual fund for an extended period (5 to 8 years), historically speaking, you are likely to draw returns amounting to around 8 per cent. However, there is no guarantee of returns under these funds.
This ratio highlights the fee that the fund house charges instead of its fund management services. It amounts to a fraction of the fund's total assets. An arbitrage fund conducts trades on a daily basis owing to which transaction costs can be high. Additionally, most of these funds are known to issue an exit load. This fee applies if an investor redeems their units within 30 or 60 days of buying them.
An arbitrage fund is ideal for investors who have allocated a short-to-medium timeframe (i.e., 3 to 5 years) for their investments. Since these funds levy exit loads, they suit those willing to stay invested for at least 3-to-6 months.
Fund returns are strongly dependent on the markets being highly volatile. Investors might want to think twice before investing in arbitrage funds if volatility is lacking.
The fund manager of an arbitrage fund is responsible for generating profits for investors over a medium time frame. It allows them to deal with the risks that volatility carries owing to exposure to equity. The fund manager then allocates the remaining assets into fixed income-generating assets.
It is the responsibility of the fund manager to ensure that high-credit quality debt securities are invested in. These exist in the form of term deposits, debentures, and zero-coupon bonds.
Arbitrage funds are treated in the same manner as equity funds as far as taxation is concerned. This means that investments that are held for under a year have short-term capital gains tax applicable, which is levied at a rate of 15 per cent.
In case investments are held for over a year, they incur long-term capital gains tax. This tax applies to returns that surpass 1 lakh and has a rate of 10 per cent. The benefit of indexation doesn't apply here.
Conservative investors who fall under higher tax brackets can consider arbitrage funds rather than pure debt funds as they provide more tax-efficient returns. It helps align the fund returns with the expectations during instances of insufficient arbitrage opportunities.
The table below gives us an understanding of the advantages and disadvantages of arbitrage funds.
While arbitrage funds can be very lucrative, especially when market volatility is significant — they can also be unreliable and expensive investments. If you choose to invest in an arbitrage fund, you should ideally complement it with additional investments in your portfolio.
Fi is here to help you manage your money. With an array of funds to choose from (including arbitrage funds), you can invest, grow and manage your money in one app. That said, it encourages responsible investing. However, this is based on the fact that you’re aware of your risk appetite. If not, speak with financial professionals and learn how these investments would fit within their investment portfolios and goals prior to investing in them.
An arbitrage fund operates by buying and selling securities in varied markets. It permits investors to profit from even the tiniest differences in prices in these markets.
Arbitrage funds are relatively safe for risk-averse individuals to keep their surplus funds in case of persistent fluctuations within the market.