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Arbitrage Funds are mutual funds that seek to profit through making profits from the difference in price for the same security across various markets. These are different from the typical equity mutual funds, which normally make money when the prices of stocks go up. Instead, arbitrage mutual funds seek to profit from the discrepancy in the prices of the same securities by making simultaneous purchases and sales.
In most cases, arbitrage mutual fund seeks to reduce the risk of the market direction of the equities. Arbitrage mutual funds are not safe investments, and do not have assured returns. They perform well where there are opportunities for arbitrage and efficient execution of the processes.
Investors seeking a short-term investment avenue with equity tax treatment should know about the arbitrage funds.
An arbitrage fund is a form of a mutual fund which tries to generate gains from the difference between prices for the same or related securities in different markets. Here, the manager of the fund makes transactions in such a way that he earns profit through difference in prices and not by depending on whether market would go up or down.
For instance, if the stock of XYZ Limited is being offered for ₹1,000 in one market and for ₹1,010 in another, then the manager of the fund can buy the stock for ₹1,000 and sell it at ₹1,010 in order to make gain of ₹10.
In this way, the manager earns profit from the difference of prices and not by holding the stock and earning profit when its price increases in the market.
Therefore, arbitration funds might be attractive for investors seeking an alternative to traditional stock funds, especially in case there are sufficient opportunities in the market to exploit them. But arbitration funds cannot be considered as risk-free or guaranteed investments.
An arbitrage mutual fund usually tries to spot instances of temporary price disparities within markets or between cash and derivatives markets. After the price disparity is noted, the fund manager can conduct buying and selling activities accordingly.
Two common cases will make the process clearer.
Consider the scenario where shares of XYZ Limited are trading at ₹1,000 in one stock exchange and ₹1,010 in another.
The fund manager can purchase the stock at ₹1,000 from the stock exchange where it is cheaper and simultaneously sell the stock at ₹1,010 from the other stock exchange.
The assumed price difference is ₹10 per share. Nevertheless, the actual profit will depend on certain factors such as commission, tax, and other transaction costs.
It implies that the price difference does not directly imply an equivalent amount of profit.
Consider the scenario where shares of XYZ Limited are trading at ₹1,000 in the cash market whereas the futures contract of the company trades at ₹1,015.
The arbitrage fund can buy the shares of XYZ Limited in the cash market and simultaneously sell the futures contract.
In case the positions match each other upon settlement of the futures contract, the arbitrage fund will be able to earn the price difference of ₹15 per share.
The above-mentioned approach tries to minimize the influence of whether stock prices increase or decrease.
While arbitrage strategies are meant to keep market exposure low, arbitrage funds are not without their risks. There are several elements that can influence the performance of an arbitrage fund.
There aren’t always arbitrage opportunities available. In situations where prices converge and there is little difference in price, there will be limited arbitrage opportunities for the portfolio manager.
Prices may move during the period when the arbitrage opportunity is discovered and the transaction is actually completed. In case the transactions cannot be done simultaneously or even at the expected price level, the expected profit from the arbitrage can diminish.
In arbitrage transactions, trading is done quite often. Commissions, security transaction taxes, exchange fees, bid-offer spreads, and other costs may eat away at the total profits earned through price differentials.
Though the strategy tries to keep away from any impact of the market trend, any unexpected market movement, along with any problem regarding settlement and derivative prices, may influence its performance.
*T&C Apply
According to the fund’s investment strategy, a certain percentage of its total portfolio may consist of debt instruments or money market securities.
No. Investing in arbitrage funds is not considered risk-free or a completely safe investment type at all.
Despite the neutral position that an arbitrage fund can adopt towards market risks by taking advantage of market inefficiencies, returns from such funds are contingent upon the occurrence of arbitrage opportunities, effective trade execution, and the cost of trading.
It is recommended that investors consider their risk appetite, investment period, and investment goals.
Arbitrage funds can be considered by investors who have a relatively short investment horizon and wish to gain from an equity strategy that does not depend solely on stock market performance.
This is conditional on the state of the markets at the time. Where volatility and price differences are high, there may be much room for profits. On the other hand, where spreads are tight and there is little opportunity, returns may prove unsatisfactory.
Investors must, however, compare arbitrage funds with other options like liquid funds and ultra-short duration funds on risk, taxes, expenses, and expected returns.
Arbitrage funds seek profits from taking advantage of discrepancies in pricing across different markets or between cash and derivative securities. The market neutral approach followed by arbitrage funds may lower reliance on the performance of the stock market; however, arbitrage funds are not risk-free or guaranteed profit-making vehicles.
Availability of opportunities, trading and transactions, and associated costs may play an important role in performance. These factors should be considered while comparing arbitrage funds with other short-term investments.
A novice investor who understands the risk associated with mutual funds and their investment objective can consider an arbitrage fund as an option.
Transaction costs, liquidity, interest rate levels, and price differentials can have an impact on returns from an arbitrage fund. Changing levels of any of the above can reduce returns.
No, an arbitrage fund does not give guaranteed returns as there might be no arbitrage opportunity in the market, and other variables like expenses and changing markets can affect returns.
The duration of holding the arbitrage fund will depend on the investment objective of the investor and the performance of the fund. The applicable exit load should be considered while exiting.
An exit load refers to a charge levied by a mutual fund on the redemption of units within a certain period. Different mutual fund schemes may have varied charges and holding periods for exit loads.
Losses can occur in cases where there is an unexpected narrowing of the expected price difference between two markets or in cases where the costs of trading outweigh the gains.
Arbitrage funds mainly exploit price differences in the equity market, while liquid funds normally hold short-term securities, including money market instruments. Returns and risks may differ for the two types of funds.
Liquidity enables fund managers to trade simultaneously and minimise the costs of trading. Lack of liquidity can prevent the exploitation of a price difference.
No, there could be variations since arbitrage opportunities differ due to market situations. A year that experiences low arbitrage will give lower returns.
There are various elements such as expense ratio, investment strategy, past performance, risks, exit loads, and fund manager’s experience. When you compare the above-mentioned elements for various schemes, it will help in selecting the fund suitable for you.
