Arbitrage Funds: Meaning, Basics, Things to Consider & More
When it comes to parking funds for short to medium term, most people choose savings bank accounts. However, as more investors are becoming aware of mutual funds, they are looking for alternative options that provide better returns without low risks such as liquid mutual funds. Arbitrage funds are one such alternative option. They are a type of hybrid fund that offer low-risk and short-term profits with better tax benefits than debt funds.
What Are Arbitrage Funds?
An arbitrage fund is an equity-oriented hybrid mutual fund which follows the arbitrage strategy of investment. In this, the fund uses the price differences of underlying assets in various capital market segments (example- stock market and futures market) to generate arbitrage profits.
An arbitrage mutual fund holds a minimum of 65% of its investment in equity and equity-linked instruments (index futures, stock futures etc.). These mutual funds can invest the funds in debt and money market instruments.
What is Arbitrage, and How Does It Work?
The following sections will explain the meaning of arbitrage and how it works:
- Arbitrage Trading Strategy
Arbitrage is a trading strategy where traders buy and sell assets simultaneously on various market segments to gain profits from their price differentials. There are two main markets where arbitrage funds engage in transactions—the cash market and the derivatives market.
In the stock market, the current value of securities, also known as spot price, is taken into consideration. While in the futures market, the expected price of securities is considered. A futures contract specifies the rate and maturity date, which is the date when a transaction will take place.
If the market moves upwards, the fund manager of an arbitrage fund buys stocks from the cash market and sells them off immediately in the futures market to make profits. But, if the market is expected to experience a downfall, the fund manager will buy a futures contract at a low price. Then, an equal number of shares in the cash market would be sold off at the spot price.
- Example of Arbitrage
Let us understand this further with an example:
The value of equity shares of Company A is Rs. 2000 in spot market, and it is Rs. 2050 in the future. If the fund manager expects the price to rise, the fund manager will purchase shares from the spot market at Rs. 2000 and short a futures contract to sell it off at Rs. 2050. When the prices of the shares converge at month-end, the fund manager can sell it off and earn a profit of Rs. 50.
Now, suppose the price of shares in the futures market is Rs. 2000 and the current price is Rs. 2050. If the fund manager feels that the current price will fall, then he would go long in the futures market and short in the cash market, to earn profits. In this case, there will also be a profit of Rs. 50 after the convergence of prices.
Features of Arbitrage Funds
Listed below are features of Arbitrage Funds:
- An arbitrage fund takes up an equal but opposite position in both spot and futures markets, which helps them to take full advantage of price differentials.
- These funds need to hold their positions in both markets until the derivative cycle ends. Moreover, they need to close their positions at the same price to realise the price difference.
- Price movements do not have any effect on the initial price differential. This is because the profit in one market supersedes the loss in another as the prices converge near expiry.
Benefits of Arbitrage Funds
Following are the benefits of these hybrid mutual funds:
- Compared to other equity funds, arbitrage funds carry minimal risks. In addition, convergence of the prices of the two markets generates virtually risk-free profits for investors of arbitrage funds.
- Since arbitrage funds depend on price differentials to generate profits, it benefits from high market volatility. This is in contrast to other equity and debt investments which perform poorly in the same situation.
- Arbitrage funds attract taxation of equity mutual funds as minimum 65% of the corpus is invested in equity & equity related instruments. It can reduce an investor’s tax obligations if he/she belongs to the higher tax bracket (ex-30%).
Who Should Invest in Arbitrage Funds?
Given below are investor personas who can consider investing in these mutual funds:
- Investors who wish to earn higher returns on their short-term funds than savings bank accounts can opt for arbitrage funds.
- People who have a low-risk appetite should consider investing in these funds.
- Retail investors with investment tenure of a minimum of 3 months should choose arbitrage funds as it is not a suitable investment option for a few days or weeks.
- People in the higher tax bracket who wish to benefit from equity taxation should ideally invest in these funds.
Essential Factors to Consider before Investment
Detailed below are essential things that you need to take into account before investing in arbitrage mutual funds:
- Associated Risks
Since arbitrage funds can invest a maximum of 35% of their assets in debt or money market instruments, there is a possibility of credit risk. So, you should evaluate the credit quality of the debt component of these funds.
In addition, please note that the returns of arbitrage funds depend mainly on market conditions. For example, in stable market conditions, there won’t be many arbitrage opportunities available in the market.
- Taxation Rules
Regarding taxation, arbitrage funds receive the same treatment as equity funds as 65% of their investment can be in equity instruments. The tax rate depends on the holding period of the investments. If you invest in the fund for less than 12 months, the capital gains are considered STCG (short-term capital gains), and the applicable tax rate is 15%.
However, if the holding period of the investments is 12 months or more, the capital gains are considered LTCG (long-term capital gains), and they are tax-exempt up to Rs. 1 lakh. The tax rate for LTCG above Rs. 1 lakh is 10% without indexation.
- Fund Manager’s Expertise
You must evaluate the fund manager’s past record to assess his knowledge and expertise in managing funds. This is essential because the fund manager will be responsible for identifying and leveraging arbitrage opportunities to fulfil the fund’s investment goal.
Fund managers often allocate a major portion of the assets to fixed-income instruments with high credit quality. This strategy facilitates stable returns at a time when arbitrage opportunities have lessened.
- Expense Ratio
It is important to evaluate the expense ratio of the fund before investing. It is the investment cost and includes the fund manager’s fee and fund management charges. Trades happen every day in an arbitrage fund, and as a result, it incurs huge transaction costs and a high turnover ratio.
Moreover, many arbitrage funds carry an exit load which is the fee that AMCs charge if investors withdraw from a fund before the stipulated time period, typically 30 days. So, you may have to pay an exit load if you decide to redeem your units within 30-60 days of buying them.
To sum up, arbitrage funds are a category of hybrid mutual funds that use the strategy of arbitrage for generating profits at relatively low risk. Conservative investors with an investment horizon of a minimum of 3 months can opt for this investment option. In addition, people in the higher tax bracket also receive tax benefits by investing in these hybrid funds.
Frequently Asked Questions
Are arbitrage funds entirely risk-free?
Arbitrage funds fall under the low to medium risk category. They are not entirely risk-free. However, they carry less risk compared to pure equity funds.
Can fund managers create alpha in arbitrage funds?
Alpha is the excess return that a fund earns above the earnings of the benchmark. Fund managers can create alpha in arbitrage funds by taking advantage of dividend arbitrage and market volatility.
Is it safe for me to invest in arbitrage funds?
Yes, it is a safe investment option for investors with low to moderate risk appetite. In addition, people who fall under the higher tax bracket can opt to invest in these funds instead of other debt funds because of the associated tax benefits.