Are arbitrage funds better investment?Asked
An arbitrage fund - a type of equity mutual fund - rides on the mispricing between the cash markets or spot markets on the one hand and derivatives or futures markets on the other. Arbitrage funds mainly take the advantage of instability in the market, that is if one stock is unit is trading at 1000 in the cash market but at 1500 in the futures market , therefore 500 of profit is made by buying from cash market and selling in futures market. Risk involved: The risk involved is very less since lot of speculation is involved while trading internally in different markets. Only when the market is stable, that is the stock units are traded equally in both the markets the returns are less.
Returns expected: When it comes to returns, arbitrage funds can fetch returns of 5-6%. But arbitrage funds are tax-free if redeemed after a year of investment. Bank FDs can fetch 6-7% and liquid funds somewhere between 6% and 8%.
Following is the list of top returns arbitrage funds based on 1 year returns:
1) ICICI Pru Blended Plan-B-Direct (G) - 10.7%
2) ICICI Pru Blended Plan - B (G)- 10.6%
3) IDFC Arbitrage Plus-B (G)-7.8%
4) Edelweiss Equity Savings Adv.-DP (D)-7%
5) ICICI Pru Blended Plan-A-Direct (G)-6.8%
Arbitrage fund is a type of equity mutual fund, takes advantage of differential pricing between the cash and futures (derivatives) markets to generate return on investment, as long as the derivatives are trading at decent premium.
To understand this, consider a firm’s share is trading at ₹100 in cash market and ₹120 in the derivative market. So, you can make profit by buying the share in cash market and sell it in derivatives market. This mispricing is the crux of arbitrage fund. The fund managers here reduce the risk of equities by hedging against the derivatives.
Characteristics of Arbitrage funds:
So, an arbitrage is best investment option in highly volatile and unstable stock market to capture rich dividends and returns. But being equity based, they involve certain amount risk.
The share price of a company can be different on different exchanges such as NSE and BSE. You can buy shares of a company from one exchange and sell them on another exchange at slightly higher prices.The funds which gain from this price difference are known as arbitrage funds.
For example, if you buy 200 shares of a XYZ stock at Rs.1000 in cash market and suppose the same stock is traded at Rs.1010 in future market. If you are able to sell the same amount of stocks in future market at Rs. 1010, you have developed an arbitrage opportunity. Derivatives stocks settles with the cash market on the expiry date of the contract.
If the stock price rises to Rs. 1020:
Profit/Loss: Rs. 4000(profit in cash market) – Rs. 2000(loss in futures market)
Net Profit: Rs. 2000
If the stock price falls to Rs. 900:
Profit/Loss: Rs. 4000(profit in futures market) – Rs. 2000 (loss in cash market)
Net Profit: Rs. 2000
In the above case, we have seen that you have gain profits in both the conditions either the price go up or down, you will end up making profits in arbitrage funds.
Top performing arbitrage funds:
Arbitrage Funds take opposite positions in different markets / securities, such that the risk is neutralized, but a return is earned. For instance, by buying a share in BSE, and simultaneously selling the same share in the NSE at a higher price.
Most arbitrage funds take contrary positions between the equity market and the futures and options market. (‘Futures’ and ‘Options’ are commonly referred to as derivatives. These are designed to help investors to take positions or protect their risk in some other security, such as an equity share. They are traded in exchanges like the NSE and the BSE.
Although these schemes invest in equity markets, the expected returns are in line with liquid funds. Also the risk in these funds is much lower than other equity schemes because these funds only look for the differences in price in 2 different markets and try to profit from the difference in the price. Therefore, the benchmark for an arbitrage fund is generally a short term money market index (most of the funds use CRISIL Liquid Fund Index as their benchmark), although these are categorized as equity schemes.
Arbitrage funds are not meant for equity risk exposure, but to lock into a better risk-return relationship than liquid funds – and ride on the tax benefits that equity schemes offer.
Also investors must keep in mind that over the years, returns from these fund have fallen down considerable because of huge inflows into these funds over the last 5 years. For better returns and higher risk investor may look at debt and other types of equity funds.
Some of the top performing Arbitrage funds are: