What Are Arbitrage Funds and How They Work

Comparable to debt funds, categorized as equity funds, nearly risk-free in nature, bearing the tax benefits of debt funds, that is Arbitrage Funds for you.

An arbitrage fund is a type of equity mutual fund that leverages the price differential of the same asset, in two or more markets to generate returns. The returns, however, are dependent on asset volatility. These funds are good at capitalizing on the market inefficiencies and reap profits for investors. Investing largely in equities, they get the same treatment as of equity funds. At the same time arbitrage funds have the potential to deliver better returns after tax at a similar level of risk as debt funds.

Here’s how arbitrage funds work, they exploit the price difference in stocks between cash and derivatives markets or even between different stock exchanges like NSE and BSE. So for instance, the price of a stock is at Rs 50 in cash market and Rs 53 in future markets. The fund manager in this case, would buy it in cash market and sell the same in the future market, simultaneously. This way the profit earned will be of Rs 3 per share.

What Are Arbitrage Funds and How They Work
Since the fund managers understand that arbitrage funds work well in volatile markets, so to capitalize the difference in prices of stock between the equity and future markets, the fund managers reduce the risk in equities by hedging the same by using derivatives. The surplus cash is deployed by Arbitrage funds in debt securities and money market instruments as well.

Trading of arbitrage funds requires skilled technique and any or all investors can’t do justice to it. With the increase in volatility, the returns might be higher. But one must not rush in as this category of investment is only for informed investors. The first bit about arbitrage strategy is to be market neutral, this means one should not get affected by movements in either direction, hence, there’s least risk involved.

If you are a conservative investor, it is quite suitable to invest in arbitrage funds. But in that case too, the investor must park only in the debt portion of the arbitrage portfolio. It is so, as the convergence of cash and future markets happens only on the expiry day and both these can be volatile till it happens. This implies that the NAVs of the arbitrage funds can also get impacted and might fluctuate as mutual funds are forced to declare daily and NAVs are based on the market to market rule.

If you are vigilant enough, you can well handle your arbitrage investments on your own or can simply rely in fund managers. A reputed manager can do justice to the trading and can take advantage of the rapid growth and potential of the existing portfolio by utilizing market information available exclusively for these market professionals.

Broadly, arbitrage trading encompasses many strategies; however they all seek to take advantage of increased chances of success. Although the risk-free forms of pure arbitrage are typically, there are several high-probability forms of risk arbitrage that offer traders and investors many opportunities to profit. Most arbitrage strategies are better known as “relative value.” These strategies are not risk free even though they try to capitalize on price differences.

For example: There could be a difference in the price of a stock on NSE & BSE or difference in the asset prices in spot and futures market, if the difference is too big arbitrage funds work wonders and give out better returns.

This is how an arbitrage fund works largely.

The biggest and the most attractive advantage, in terms of investors, of investing in an arbitrage fund is that Arbitrage funds are classified as equity funds from a tax point of view. This happens because arbitrage funds provides benefits of zero taxes on holding time of over a year. In the event that the holding period is not as much as a year, capital increases (short-term) are taxed at 15 percent.

There are a number of arbitrage strategies which a fund may adopt such as Index/ Stock Spot – Index/Spot Futures, hedging & alpha strategies, and event driven strategies etc. Therefore, arbitrage funds are one of the best mutual funds to invest in.

Author Bio – Having varied interests and diverse knowledge, Himani Arora writes articles for several sectors and categories in personal finance, mutual funds India and investments for reliancemutual.com

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