Many investment experts believe that arbitraging is the best way to generate wealth. Arbitraging works on mispricing equity shares in the spot and future markets. Arbitrage funds buy and sell assets, focusing on benefiting from price differences between markets. This article will discuss arbitrage funds and their various features and aspects you should know.
Let’s begin our discussion by understanding ‘what is arbitrage?’
What is arbitrage?
Arbitrage refers to the simultaneous buying and selling of an asset in two different markets to profit from price inefficiencies between the markets. The cash and the futures market are the two markets for arbitrage. The arbitrage funds are based on this principle.
It may sound complex to a layperson. But arbitraging is pretty straightforward once you understand the difference between cash and future markets.
In the cash or spot market, transactions happen in real-time. An example of a spot market is the secondary market for equity shares on NSE or BSE, where your account gets debited immediately when a trade is executed.
In the futures market, you can buy the rights to purchase or sell equity shares on a future date at a predetermined price. The price of an asset in the futures market can be higher or lower than the spot market depending on investors’ sentiment. The difference between the spot and the futures market is what arbitrage funds try to capitalise on.
What are arbitrage funds?
Arbitrage funds are mutual funds that work on the principle of arbitrage. These funds aim to generate profit for investors by transacting in the derivative and the cash market. For instance, a fund manager will buy an asset on the cash market at a spot price and sell it in the futures market at a higher price, realising a profit from the price difference.
Before we discuss further details, let’s understand an arbitrage trade with an example.
Suppose you have purchased 5000 shares of company X at Rs 200 per share (Rs 10,000,00) and sell 5000 shares in the future market for Rs 205. If all goes well, you will realise a gain of (Rs 10,25,000 – 10,00,000) Rs 25,000 from the transaction.
Now, if the market plummets and the share price declines to Rs 195 per share in the spot market and Rs 190 in the futures market. In this case, a trader in the spot market will lose Rs (10,00,000 – 9,75,000) or Rs 25000. However, an arbitrage fund will be able to capitalise in this situation.
The fund will lose Rs (Rs 200-195) in the spot market but will gain Rs (205-190) in the future market. The fund will earn a total profit of Rs (75000-25000) or Rs 50000.
It is an overly simplified illustration for your understanding. In reality, the trades are more complex, and mutual funds earn much less from single transactions.
Arbitrage funds risks
It is interesting to know that arbitrage funds are comparatively low risk. When market volatility rises, arbitrage funds tend to perform well. Since the funds simultaneously buy and sell assets, they avoid the risks associated with long-term investments. If you invest in an arbitrage fund, volatility remains your least concern. As long as the market keeps moving in either direction, a fund manager will find opportunities to capitalise on.
However, these funds generate below-market returns when the market moves in a range.
Arbitrage funds are hybrid funds which invest a small portion in debt instruments. But these are usually short-term deposits or very short durations. Hence, the credit risk arising from investing in debt funds is also minimum in arbitrage funds.
Who should invest?
Arbitrage funds are designed to generate low-risk profits from simultaneously buying and selling assets. Their low risk is comparable to the risk of pure debt funds, and the top arbitrage funds follow Crisil BSE 0.23% Liquid Fund Index as their index. So, these funds are suitable for risk-averse investors to park their surplus capital safely when there are persistent market fluctuations. However, investors must compare the best arbitrage funds returns and select the suitable one.
Arbitrage funds returns
So, what to expect about arbitrage funds returns? Returns from the fund depend on the number of arbitrage opportunities available in the market. Hence, arbitrage funds perform better when the market is fluctuating and arbitrage options are abundant.
Things to remember while investing in arbitrage funds
Role of fund manager
The fund manager is responsible for effectively identifying and leveraging arbitrage opportunities to continue generating returns for the fund.
Since these funds trade on the stock exchanges, no counterparty risks are involved. Arbitrage funds don’t attract risks like other diversified equity mutual funds. However, as more investors try to capitalise on arbitrage opportunities, the scope of the market starts to wane, leaving fewer opportunities to benefit from.
The fund manager simultaneously buys and sells the asset to generate income. But these opportunities are narrow, and so the returns are average. You can expect around 8% returns if you stay invested for 5-8 years.
Cost of investment
These funds charge an annual expense ratio, which includes the fund manager’s fee and fund management charges. The expenses ratio is a percentage of the total fund invested.
Arbitrage funds are treated as equity funds, and taxes are levied on them per the capital gain tax rules. If you invest for less than a year, a short-term capital gain tax of 15 percent will be attached to your capital gain.
These funds are excellent when you have short or medium-term investment goals. You can park your surplus capital in arbitrage funds instead of a regular savings account and create an emergency fund while earning higher returns.
Top five arbitrage funds in India
- Nippon India Arbitrage Fund
- Edelweiss Arbitrage Fund
- L&T Arbitrage Opportunities Fund
- UTI Arbitrage Fund
- Kotak Equity Arbitrage Fund
You must research before you invest.
Now you have learned the arbitrage fund meaning, research the market for the best arbitrage funds according to your financial goals for investing. Open a Demat account and start investing with Angel One in various investment products.
Disclaimer: “This blog is exclusively for educational purposes and does not provide any advice/tips on Investment or recommend buying and selling any stock”