Many investment experts believe that leveraging arbitrage opportunities is the best way to generate wealth. Arbitrage is about finding a price difference of the same security between two or more markets and capitalizing on it. As an investor, if you find the price of a stock to be different in the futures and spot markets, then you have an opportunity to cash in on it. However, this requires a lot of research and understanding of the way the market functions. However, not all investors have the knowledge or the time to dedicate to research.
This is where Arbitrage Mutual Funds step in. Here, we will talk about Arbitrage Funds and explore various features and aspects that you should know before investing in them.
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Arbitrage Funds are equity-oriented hybrid funds that leverage arbitrage opportunities in the market. These can be a pricing mismatch between two exchanges, different pricing in the spot and futures market, etc. The fund manager of an arbitrage fund buys and sells the shares at the same time and earns the difference between the selling price and the buying price of the share.
This is fundamentally different from any other form of investing, where you purchase an asset and wait for it to grow in value before selling it.
In an arbitrage fund, the fund manager invests in equities only when he finds a definite opportunity to earn returns. If there are no arbitrage opportunities available, then the fund invests in short-term money market instruments and debt securities. The important thing to note here is that the price difference is usually very small. Therefore, the fund manager has to make several trades in one day to book a reasonable profit.
The major features of an arbitrage fund are:
They are Equity-oriented
Equities and equity-related products must account for at least 65% of the portfolio.
Provide Hedged Exposure
The portfolio will primarily contain hedged exposures.
Low-risk Funds
These funds have the potential to outperform non-equity-oriented funds in terms of post-tax returns.
Suitable in Unstable Markets
Such funds are the only low-risk investment that thrives in a volatile market.
Let's look at the two possible scenarios where arbitrage opportunities exist:
Scenario #1: Price Difference between Exchanges
Let's say that the stock of XYZ Limited is selling at Rs. 1000 per share on the Bangalore Stock Exchange (BgSE) and at Rs. 1010 per share on the Ahmedabad Stock Exchange (ASE).
If the fund manager of an arbitrage fund spots this opportunity, then he buys shares from the BgSE and simultaneously sells them on the ASE. This allows him to make a profit of Rs. 10 per share (less transaction costs) without any risks.
Scenario #2: The Price Difference between the Cash and Futures Markets
Let's say that the share of XYZ Limited trades at Rs. 1000 in the cash market and Rs. 1015 in the futures market. The fund manager of the arbitrage fund buys shares from the cash market and creates a futures contract to sell the shares at Rs. 1015. At the end of the month, he sells the shares in the futures market and books a profit of Rs. 15 per share (less transaction costs) without taking any risks.
You can invest in an Arbitrage fund through an intermediary or an AMC. You can also do this through Groww with ease.
You may avail of the listed benefits by investing in these funds-
Lower Risks
Arbitrage funds typically have a minimal amount of risk for the investor. Because each security is bought and sold at the same time, there is essentially no risk associated with longer-term investments. Arbitrage funds may also invest a portion of their capital in debt instruments, which are generally seen as fairly stable.
When there is a scarcity of attractive arbitrage deals, funds increase their debt exposure. This makes this form of investment particularly enticing to investors who have a low-risk tolerance.
Taxation
Although such funds generally invest in equities, they are technically balanced or hybrid funds because they invest in both debt and equity. As a result, they are taxed as equity funds because long equity accounts for at least 65% of the portfolio on average.
Taxation Rules of Arbitrage Mutual Funds
For taxation purposes, Arbitrage funds are treated similarly to equity funds with the following tax rules:
Q1. What is arbitrage funds meaning?
Arbitrage funds are mutual funds that seek to profit on price differentials in the derivatives and cash (or spot) markets by engaging in simultaneous buy and sell transactions in cash and futures markets.
Q2. Who can invest in arbitrage funds?
These funds are usually suitable for new investors and investors with low-risk appetite.
Q3. How are the returns of arbitrage funds?
The profits of an arbitrage fund are primarily determined by the number of arbitrage opportunities available in the market as well as the fund manager's ability to capitalize on these possibilities. Arbitrage opportunities abound in tumultuous markets and are limited in tranquil markets. However, such funds outperform both FDs and liquid funds on average.
Q4. What are some of the risks or demerits of investing in Arbitrage funds?
The risks associated with arbitrage funds are unpredictable payoffs and high expense ratios.
Q5. What is the benefit of investing in Arbitrage funds?
Arbitrage funds, unlike other funds, place huge orders and profit from price differentials for the same security in several marketplaces. This enables investors to profit from market volatility while assuming minimal risk.
Disclaimer - Mutual Fund investments are subject to market risks; read all scheme-related documents carefully.
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