Features of arbitrage mutual funds
Imagine buying low and selling high instantly. That is the magic of arbitrage funds, a hybrid that combines equity's growth potential with a low-risk approach. Here is why they are a game-changer:
- Stock market ninjas: They exploit price differences between similar securities, like a stock on sale in one exchange and full price elsewhere. Buy low, sell high, profit!
- Hedged for safety: They minimise risk by using hedging techniques, making them a steadier option than pure equity funds.
- Market mayhem? No problem: When markets get shaky, arbitrage funds can shine, offering potentially better returns than non-equity funds.
Benefits of investing in arbitrage mutual funds
- Potentially lower risk: Compared to traditional equity funds, arbitrage funds aim to capture price discrepancies between securities, resulting in lower risk. Since these funds exploit short-term price inefficiencies, they are less susceptible to broad market movements.
- Potential for steady returns: By capitalising on price differences, arbitrage funds can offer steady returns, even in volatile markets. This makes them a good option for investors seeking stability in their portfolio.
- Tax advantages: Similar to equity funds, arbitrage funds benefit from tax advantages. Long-term capital gains exceeding Rs. 1 lakh are taxed at 10%, while short-term capital gains are taxed at 15%.
Arbitrage fund returns
- Returns comparable to short-term debt: Arbitrage funds typically generate returns comparable to those of short-term debt instruments like fixed deposits (FDs) or liquid funds. However, they may potentially outperform these options due to their equity taxation benefits.
- Unpredictable payoffs: The returns from arbitrage opportunities can be unpredictable. Market inefficiencies, which the funds exploit for profits, may not always be readily available.
Risks in arbitrage funds
- High expense ratios: Compared to other debt funds, arbitrage funds often carry higher expense ratios. This is because they require active management to identify and capitalise on arbitrage opportunities.
- Limited profit potential: The profit margins from arbitrage tend to be small. This limits the overall return potential of arbitrage funds compared to other equity-oriented options.
- Interest rate risk: Since arbitrage funds may invest a portion of their corpus in debt instruments, they are susceptible to interest rate fluctuations. Rising interest rates can lead to a decline in the net asset value (NAV) of the fund.
Who should invest in arbitrage mutual funds?
Arbitrage mutual funds are suitable for investors who:
- Want to invest in low-risk investments: Are looking for short-term to medium investments: Individuals looking for a short-term to medium term investment horizon
- Want to diversify their portfolio
Should you invest in arbitrage mutual fund?
Arbitrage mutual funds can be a suitable option for conservative investors seeking relatively stable returns with minimal equity market risk. These funds exploit price differences in the cash and derivatives markets to generate returns. While not as volatile as pure equity funds, they may still outperform debt funds in certain market conditions. They are also treated as equity for taxation, which offers favourable capital gains tax benefits after one year. However, they may not be ideal during low volatility periods, as arbitrage opportunities can reduce. Consider your risk profile, investment horizon, and return expectations before investing in these funds.
Factors to consider before investing in arbitrage mutual funds in India
1. Risk
Arbitrage funds may not carry price or counterparty risk, but those investing in debt securities could face credit risk. Additionally, their performance might be weak in bearish markets where futures prices may fall below spot prices.
2. Return
These funds aim to offer moderate returns. They are appropriate for investors looking to earn income over the short to medium term. However, like all market-linked options, returns are not assured.
3. Investment Horizon
Arbitrage funds are generally considered ideal for investors planning to stay invested for three to six months.
4. Investment Amount
Lump sum investments are generally preferred in arbitrage funds over systematic investment methods like SIPs.
5. Scheme Offer Document
Before investing, one should go through the scheme’s offer document. It outlines key details such as the fund’s objectives, strategies, risks, costs, and asset mix.
6. Asset Allocation
These funds invest across equity and debt instruments. It is essential to evaluate how the allocation suits your financial goals and ability to bear risk.
7. Management Fees
All mutual funds, including arbitrage funds, charge a fee for portfolio management. This fee is deducted from your earnings and affects overall returns, so it should be reviewed in advance.
Arbitrage Fund vs. Liquid Fund: Which is Better?
Each of these funds serves a different investment purpose, and choosing between them depends on the investor’s financial needs and time horizon.
- Returns Comparison
Over a 6-month period, arbitrage funds yielded approximately 2.13% compared to 1.73% from liquid funds. At the 1-year mark, returns were 4.06% and 3.41% respectively. Across 3 years, arbitrage funds offered 5.21%, slightly ahead of liquid funds at 4.87%.
- Tax Efficiency
Arbitrage funds are treated as equity for taxation, benefiting from lower taxes on long-term capital gains. In contrast, liquid funds are classified as debt instruments and are less tax-efficient, especially for longer holding periods.
- Risk Measures
Arbitrage funds recorded a standard deviation of 0.93 and a Sharpe ratio of 1.38, while liquid funds had a lower standard deviation of 0.67 and a higher Sharpe ratio of 2.01, indicating better risk-adjusted performance.
Key takeaways
- Arbitrage funds exploit price differences in cash and derivatives markets for low-risk returns.
- They combine equity growth potential with hedging techniques to minimize risk.
- Suitable for short to medium-term investors seeking portfolio diversification.
- Taxed as equity funds, offering favorable tax benefits for long-term gains.
- Higher expense ratios and limited profit margins are key risks to consider.
- Evaluate expense ratios, returns, and fund manager expertise before investing.
Conclusion
Arbitrage mutual funds present a good investment option for individuals seeking a balance of returns and risk mitigation. By capitalising on price discrepancies in the financial markets, these funds aim to generate returns. However, Mutual Fund Investments are subject to market risks, read all scheme related documents carefully. Investors should carefully consider their investment horizon, market conditions, tax implications, expense ratio, exit load, fund manager’s experience, and fund size before diving into this unique segment of mutual funds in India.
Start investing in Arbitrage mutual funds now, on the Bajaj Finserv platform!Start investing in Arbitrage mutual funds now, on the Bajaj Finserv platform!
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