What Are Arbitrage Mutual Funds And How Do They Work – Forbes Advisor INDIA

Arbitrage mutual funds are hybrid mutual fund schemes which leverage the price difference in markets to generate profits. The main aim of arbitrage funds is to generate arbitrage profits through price differences in different capital market segments. 

Arbitrage means buying and selling of security simultaneously in different markets to make risk free profits. If the price of a security is different in different markets, investors can make risk free profits by buying the security in the market where price is lower and simultaneously selling the security in markets where price is higher. 

Arbitrage funds are suited for investors with low risk appetite. As per the Securities Exchange Board of India’s (SEBI) directive, arbitrage funds must invest at least 65% of their assets in equity and equity related securities.

How Do Arbitrage Mutual Funds Work?

For the purpose of understanding, let’s assume that the equity shares of a particular company are trading at INR 2,000 in the spot market. Simultaneously, the fund manager sees that in the futures market, the same shares are trading at INR 2020. 

The fund manager uses this differential pricing to their advantage, by buying the shares in the spot market for INR 2000. The fund manager then sells the same number of shares at the futures market for INR 2020. When the futures market contract expires at the end of the month, the prices at both the markets tend to coincide, and at this time, the fund manager will be able to generate a risk-free profit from the differential amount, which is INR 20 per share. 

In a similar way, the fund manager can do the same and take advantage of differential pricing between two different stock exchanges as well. For instance, shares can be bought at INR 100 on the National Stock Exchange (NSE), and sold at INR 110 at the Bombay Stock Exchange (BSE), thereby making a profit of INR 10 per share. 

Role of an Arbitrage Fund Manager

Arbitrage funds take advantage of differential pricing between two markets to generate profits over a medium time horizon. When this is done, the risk of volatility is mitigated. A fund manager is responsible for allocating the remaining assets to fixed-income generating instruments. 

The fund is also responsible for ensuring that all investments are made in trustworthy, high-credit quality debt securities. A few examples of this are term deposits, zero-coupon bonds, or debentures. In doing so, the fund returns are kept in line with any expectations during the period of inadequate arbitrage opportunities.

Risks Associated With Arbitrage Mutual Funds

Like everything else in the world of investments and finance, arbitrage funds too are not without risks. Generally, arbitrage funds are considered a low-risk investment option. This is because the fund manager purchases and sells securities simultaneously, with lower chances of risks or losses. When it comes to arbitrage funds, volatility of the market actually works as a boon. Arbitrage opportunities will always be available when a market is constantly on the move, thus allowing fund managers to capitalize on it. 

However, these funds may not generate the desired returns when the market moves in a range.

Who Should Consider Investing In Arbitrage Mutual Funds?

If you are considering investing in an arbitrage fund, it is best to ensure that you tick one or more of the following boxes:

1. Investment horizon: Since these funds take advantage of price movements in the short term, an ideal investment horizon can be of at least six to 12 months.
2. Low-risk investments: Arbitrage funds take very low risk relative to other hybrid and equity-oriented funds. Investors could consider investing in arbitrage funds if they do not wish to take higher risk associated with pure equity funds. 
3. Taxation benefits: When it comes to taxation, arbitrage funds are treated the same way as equity funds. Thus, all the profits you make in one year of investment will be treated as short-term capital gains, which will then be taxed at 15%. 

Profits that are made after one year of investment will be treated the same as long-term capital gains. If the profits that you make are within the INR 1 lakh bracket, you will be exempt from tax while any profits exceeding INR 1 lakh will be subjected to 10% tax. For those who are keen on the importance of tax efficiency, then arbitrage funds could also be considered as a great investment opportunity. 

Things to Keep In Mind before Investing In Arbitrage Mutual Funds 

Before you deep dive into the world of arbitrage funds, it is imperative that you take the following into consideration: 

Arbitrage funds are a great choice if you have short -term financial goals. For example, instead of putting your money into a regular savings bank account, you could instead choose to park any excess funds that you have to create an emergency fund to gain higher returns through arbitrage funds. 

• Understanding all the risks involved 

No mutual fund is without risks. Although arbitrage funds are relatively low-risk in nature, it is best to consult with a financial advisor/mutual fund distributor before investing into these categories of funds.

Returns from arbitrage funds are dependent on the difference between the spot market and the futures market. When played right, an arbitrage fund is a great option for those who want to earn reasonable returns on the money that is invested. Over the last one year, this category of funds has given an average return of 3.38%; while over the last three years on an average the category has delivered 3.60% (as on Oct. 31, 2022).

Ensure that the expected returns are aligned with your expectations. 

Arbitrage funds are meant to park money for short term goals such as emergency funds or setting aside the money for short term liquidity needs. As mentioned earlier, since these funds take advantage of price movements in the short term, an ideal investment horizon can be of at least six to 12 months. Arbitrage funds tend to perform better during volatile market conditions. Investors can choose to invest in low-risk debt funds during stable market conditions. This means that investors have to keep an eye on the overall market before investing in arbitrage funds. 

Investors should be aware of the costs while investing in arbitrage funds. An annual fee known as the expense ratio will be charged; this covers the fund manager’s fee as well as the fund management charges. Since arbitrage funds involve frequent trading, chances are that you will incur transaction costs and even a high turnover ratio. In order to discourage investors from making an early exit, exit loads for a period of one to two months will be levied as well. All of these factors should be considered before investing in the arbitrage funds. 

Bottom Line 

While most mutual funds struggle at the time of market volatility, arbitrage funds can have the potential to generate higher returns. Arbitrage funds do not generate higher returns during stable market conditions. Investors should carefully consider the risks involved with arbitrage funds and should have a minimum horizon of at least six to 12 months before investing in these funds. 

Also, investing in these funds provide investors the benefit of better post-tax returns if held more than one year as these funds are taxed similar to equity funds. Moreover, it is essential to keep a close track on the debt portion allocation of arbitrage funds and the credit quality.

Investors could consider investing a part of their investment portfolio in arbitrage funds in order to cope up with market volatility as these funds can generate reasonable returns. Investors should carefully consider their financial liabilities, risk appetite, and time horizon before investing in arbitrage funds.