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.
Arbitrage Funds are equity-oriented hybrid funds which 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.
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 funds 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: 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.
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The risk profile of an arbitrage fund is like that of a debt fund. You will find various arbitrage funds using liquid fund index as the benchmark for their fund. Arbitrage funds are ideal for investors who want to invest in equity but don’t want to bear the risks. In a fluctuating market, many investors who are averse to risk can park their money in an arbitrage fund and earn good returns.
Here are some important aspects that you must consider before investing in arbitrage funds in India:
Role of the Fund Manager
The fund manager identifies arbitrage opportunities and leverages them to achieve the investment objective of the scheme. Additionally, he allocates a small portion of his assets to fixed-income instruments having a high credit quality. This allows him to maintain stable returns even when the arbitrage opportunities are few.
Risks and Returns
There is no equity exposure risk since the fund manager buys stocks in one market and simultaneously sells them in another. However, these opportunities are few and the price difference is very small. Therefore, the returns are average. If you stay invested for 5-8 years, you can expect returns of around 8%. However, you must remember that in arbitrage funds, there is no assurance of returns.
The expense ratio which is a percentage of the fund’s total assets is the fee charged by the fund house for offering fund management services. In an arbitrage fund, trades are done every day. Therefore, transaction costs can be huge. Further, many arbitrage schemes levy an exit load if you redeem your units within 30 or 60 days of purchasing them.
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You need to be invested in arbitrage funds for at least 3-5 years to earn reasonable returns. Most arbitrage funds charge an exit load which needs to be factored in before investing. Arbitrage funds thrive in volatile markets. Hence, it is better to invest lumpsum as opposed to a systematic investment plan. If the markets are not volatile, then liquid funds tend to offer better returns than these funds.
Instead of parking your funds in a normal savings account, you can choose to invest them in an arbitrage fund. This will help you earn better returns on your stagnant money. However, if you are already invested in equity-oriented funds, then you can systematically transfer funds from the equity fund to the arbitrage fund. While this will reduce the returns, it will also bring down the risk drastically.
For taxation purposes, Arbitrage funds are treated similar to equity funds with the following tax rules:
So, if you are in a higher tax bracket, then investing in an arbitrage fund is better than outing your money in a debt fund and paying more tax on the gains.
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