Arbitrage Funds
Before divulging into Arbitrage Mutual Funds, let’s understand what does arbitrage mean?
Arbitrage is the practice of buying something (for example, shares or foreign money) in one place and selling it in another place where the price is higher.
Arbitrage funds are distinct in their investment approach and aim to generate returns from the price disparities of the same asset in different market segments, mainly the cash and futures markets. Arbitrage Funds invest in a mix of equity and debt. As per SEBI’s categorisation circular, arbitrage funds shall have a minimum 65% in equity and equity-related instruments.
The fund manager buys equity shares of a company and shorts an equal quantity of the same security in futures segment. This is done in a manner to earn through the price difference in both the segments.
In arbitrage funds, equities are only purchased when clear opportunities for returns are identified. In the absence of such opportunities, the fund invests in short-term money market instruments or debt securities, while keeping a minimum of 65% allocation equity and equity-related instruments.
How do Arbitrage Mutual Funds Work?
To understand how arbitrage funds operate, here’s a breakdown of their working process:
- Identifying Price Gaps: The fund manager identifies assets with price differences between the cash and futures markets.
- Simultaneous Transactions: For instance, if a stock is priced at ₹100 in the cash market and ₹102 in the futures market, the fund buys the stock at ₹100 and sells it in the futures market at ₹102, securing a profit of ₹2 per share.
- Utilizing Market Volatility: In volatile markets, price differences are more frequent, providing opportunities for arbitrage funds to generate returns.
- Investing in Debt Instruments: During periods with fewer arbitrage opportunities, these funds may invest surplus cash in low-risk debt instruments to ensure consistent returns as per asset allocation of the concerned scheme.
Benefits of Investing in Arbitrage Mutual Funds -
Arbitrage funds may generally carry a low to moderate risk profile as they rely on price discrepancies in the market, which might make them a suitable option for conservative investors.
Arbitrage funds are treated as equity funds for taxation, offering potential tax benefits: STCG from arbitrage funds held for less than 12 months is taxed at 15%, while LTCG from such funds held for 12 months or more is taxed at 12.5%. Additionally, LTCG of Rs. 1.25 lakh from equity shares and equity-oriented funds in a year is tax-exempt.
Risks in Arbitrage Funds -
- Arbitrage opportunities can diminish in highly efficient markets where price discrepancies are quickly corrected.
- Frequent trading to exploit price differences can lead to higher transaction costs, which may affect the fund’s net returns.
- Extreme market conditions can lead to higher-than-expected volatility.
Who Should Invest in Arbitrage Mutual Funds?
Arbitrage Funds may be suitable for investors who -
- Are looking for a short to medium term investment horizon.
- Are looking to diversify risk
- Are looking for Income over short term Investments in equity and equity related securities including derivatives for taking advantage from the price differentials / mis-pricing prevailing for stock / index in various segments i.e Cash & Futures
Conclusion -
Arbitrage funds can be a portfolio option for those seeking a balance between risk and return, particularly in volatile markets. They offer a distinct strategy that can diversify an investment portfolio. With their combination of potentially lower-risk opportunities and the possibility of consistent returns, arbitrage funds may be attractive, especially during uncertain market conditions. However, investors should carefully consider their risk tolerance, investment goals, and market conditions before investing.
Mutual Fund investments are subject to market risks, read all scheme related documents carefully.
Please note that this article or document has been prepared on the basis of internal data/ publicly available information and other sources believed to be reliable. The information contained in this article or document is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party in any manner. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article or document.
Published on March 25, 2025
