What are Arbitrage Funds?
Arbitrage funds are a type of hybrid mutual funds that aim to generate returns by simultaneously buying and selling securities in different markets {Cash (spot) market & Futures market} to take advantage of price differences, they rely on the price difference between two markets. These funds are considered low-risk investments.
How do Arbitrage Mutual Funds work?
Arbitrage mutual funds work by generating income through opportunities emerging out of difference in pricing between cash and derivatives market. The fund manager buys a security in one market and sells it in another market at a higher price, thereby making a profit. The profit is the difference between the buying and selling prices of the security.
Here's how they work with an example:
- Identifying Price Differentials: Arbitrage fund managers identify securities or assets that are trading at different prices in the cash market (spot) and the derivatives market (futures and options). For example, let us consider shares of XYZ Ltd. trading at Rs. 100 in the spot market and Rs. 105 in the futures market for a one-month contract.
- Buying in the Cash Market: The fund manager purchases the security (in this case, XYZ Ltd. shares) at the lower price in the cash market, which is Rs. 100 per share.
- Simultaneous Selling in the Derivatives Market: To profit from the price differential, the fund manager sells an equivalent amount of XYZ Ltd. shares in the futures market at the higher price of Rs. 105 per share.
- Locking in Profits: By buying low in the cash market and selling high in the futures market, the fund creates a risk-free position and locks in a profit of Rs. 5 per share (Rs. 105 - Rs. 100).
- Repeating the Process: Arbitrage Mutual Funds continuously identify such opportunities across various securities and derivatives, allowing them to generate returns over time.
- Adding Up the Gains: The fund aggregates these small gains from multiple arbitrage opportunities, and the cumulative profit contributes to the fund's returns.
- Managing Expenses: While arbitrage funds aim to minimize risk, they may incur expenses related to trading costs, fund management fees, and other operational expenses.
It is important to note that arbitrage funds are considered low-risk investments because they seek to take advantage of the price discrepancies rather than market direction. The returns generated are comparatively less volatile than those of pure equity funds.
Features of Arbitrage Mutual Funds
Here are some features of arbitrage mutual funds:
- Moderately low-risk investments, minimal stock market risk
- Generate returns through price differences, arbitrage funds, might generate positive returns even when the market is volatile.
- Suitable for investors with a short-term investment horizon
- Arbitrage funds exhibit tax efficiency similar to equity funds, making them a favourable investment option from a tax perspective.
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
Factors to consider before investing in Arbitrage Mutual Funds in India
Before investing in arbitrage mutual funds, investors should consider the following factors:
- Expense ratio: The expense ratio of the fund should be low.
- Returns: Investors should compare the returns generated by different arbitrage mutual funds before investing.
- Taxation: Arbitrage mutual funds are taxed as equity mutual funds since minimum 65% of their holdings need to be in equities.
Hence, for an investment period of less than one year, short-term capital gains (STCG) are taxed at 15%, while investments held for over a year with returns under one lakh are classified as long-term capital gains (LTCG) and are entirely tax-free. When returns exceed a lakh, the LTCG tax rate is 10%, without indexation benefits.
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.
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