Arbitrage Funds

Arbitrage funds exploit price differences between markets (cash vs futures) by buying low in one and selling high in another for profits.
EXPLORE FUNDS
Arbitrage Funds
EXPLORE FUNDS
4 mins read
18-May-2024

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 and Futures market} to take advantage of price differences, they rely on the price difference between two markets. These funds are considered low-risk investments. In this article, you will learn about arbitrage funds meaning, how arbitrage funds work, arbitrage funds features and many more in detail.

What are arbitrage funds?

Arbitrage funds are a type of investment strategy within hybrid funds. These funds exploit price differences between similar securities in different markets. Imagine buying a stock on one exchange for Rs. 100 and simultaneously selling it on another for Rs. 102. The small profit (arbitrage) is captured by the fund.

Since arbitrage funds deal with stocks, they are technically classified as hybrid funds because they hold a mix of equity (stocks) and debt instruments (for short-term parking of money). However, their low risk profile makes them more attractive to investors seeking stability compared to traditional equity funds.

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.

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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

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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Frequently asked questions

Are arbitrage funds hybrid funds?

Arbitrage Funds belong to the category of equity-oriented hybrid funds that exploit market arbitrage opportunities, such as pricing disparities between two exchanges or variations between spot and futures market prices.

How long should I stay invested in arbitrage mutual funds?

Investors can choose their investment horizon, but arbitrage funds are generally considered medium-term investments, with a recommended holding period of at least an year.

Are arbitrage funds better than FD?

The choice between arbitrage funds and fixed deposits depends on individual preferences and financial goals. Arbitrage funds may offer potentially higher returns but come with market-related risks, while FDs provide capital safety and fixed returns.

Is it safe to invest in arbitrage funds?

Compared to equity funds, arbitrage funds are generally considered safer. They target short-term price discrepancies, aiming to minimise risk from market fluctuations. However, no investment is entirely risk-free.

What are the disadvantages of arbitrage funds?

While offering potentially steady returns, arbitrage funds come with limitations. Expense ratios can be higher due to active management. Profit margins are typically small, capping overall returns. Additionally, they are susceptible to interest rate fluctuations.

Is an arbitrage fund tax-free?

No, arbitrage funds are not tax-free. They benefit from similar tax treatment as equity funds. Long-term capital gains exceeding Rs. 1 lakh are taxed at 10%, while short-term gains are taxed at 15%.

Can arbitrage funds give negative returns?

Yes, although unlikely, arbitrage funds can experience negative returns. This can occur if market inefficiencies, the source of their profits, are scarce or if expenses outweigh gains.

What is the difference between an arbitrage and hedge fund?

Both strategies exploit market inefficiencies, but arbitrage funds focus on short-term price discrepancies with lower risk profiles. Hedge funds, on the other hand, employ a broader range of strategies that can be riskier but aim for higher potential returns.

What is the rate of return of an arbitrage fund?

Arbitrage funds typically generate returns comparable to short-term debt instruments like fixed deposits, but with potential tax benefits from being classified as equity funds.

What is the Nifty 50 arbitrage index fund?

A Nifty 50 arbitrage index fund replicates the returns of the Nifty 50 Arbitrage Index. This index tracks the price difference between the Nifty 50 stocks and their corresponding futures contracts. It offers a passively managed option to participate in arbitrage opportunities.

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