Arbitrage Mutual Funds

• Arbitrage funds earn gains by simultaneously buying and selling securities in two different markets. These markets are the spot-cash market and the futures market. The fund manager simultaneously buys shares in the cash market and sells them in futures or derivatives markets. The difference between the cost and selling prices is the return you earn. In a nutshell, arbitrage funds work by benefiting through price differences in diverse markets.

• Due to its nature of buying and selling at low risk in the futures and the cash market, fund managers can easily calculate the kind of risk involved in arbitrage funds.
• Hence this type of financial instrument is perfect for individuals who wish to take advantage of the market volatilities without engaging in high risk.

• Since arbitrage opportunities tend to be more in case of volatile markets, the fund is likely to generate potentially higher returns than in a stable/calm market. However, these funds are known to give higher returns than a fixed deposit.
• Managers buy and sell stocks at low risk in the futures and the cash market so they can easily calculate the kind of risk involved in arbitrage funds.
• Since the manager is actively involved in buying and selling stocks simultaneously in two markets, arbitrage funds are categorised as actively managed funds
• They generate profit by operating in different markets.
• As the fund manager is usually aware of the buying and selling prices, the investors can remain assured even during economically volatile times.
• When the arbitrage opportunities are low, the fund manager can use the investor capital in the choice debt instruments, which can be used to generate capital and can help with high credit quality. This can be done through instruments such as government bonds, debentures, and term deposits.
• Even the best arbitrage funds can be volatile, but they’ve been known to return on par with liquid funds over the long term.
• High expense ratio - The number of trades required to make profits from arbitrage funds can bring up the expense ratio. However, expense ratios are a key factor to be considered when investing in arbitrage funds.

• Despite investing in equities, arbitrage funds are considered hybrid funds as they invest both in equity and debt funds. As long as equity makes up for 65% of the portfolio, they are taxed as equity funds.
• When an investor earns dividends on their arbitrage fund investments, the dividends are included in their taxable income and subject to taxation based on their income tax bracket. In addition, if the dividend amount exceeds Rs. 5000 in a financial year, a 10% Tax Deducted at Source (TDS) is applied to the excess amount.

As said earlier, capital gains of arbitrage funds are taxed as equity-oriented funds. Here’s how:

1. Short-Term Capital Gains - In the case of assets owned for less than 12 months, a tax rate of 15% is applied to gains from arbitrage funds.
2. Long-Term Capital Gains - If you hold the investment for more than 12 months, a long-term gain tax of 10% is applicable, without indexation on a gain of more than 1 lakh in a financial year from these funds.

Here are some other risk factors involved:

1. Unpredictable returns - Arbitrage funds are not entirely reliable in stable markets. In the absence of profitable arbitrage trades, this may lead the arbitrage fund to become a bond fund
2. High expense ratio - The number of trades required to make profits from arbitrage funds can bring up the expense ratio. While it will be a well-suited practice to opt for a lower-expense ratio, investors must also focus on a good performance track record. The expense ratio should not be the only deciding factor when choosing an arbitrage fund

1. Low risk - Since securities are bought and sold simultaneously, there is less risk involved in long-term investment. Part of the arbitrage funds is also invested in debt securities which are considered to be relatively stable. Hence this investment option turns out to be a suitable option for investors who have a low-risk tolerance. Being low-risk securities, these funds can thrive during market volatility. When prices are unstable, the differences between cash and the futures market increase.
2. Liquidity - Arbitrage funds don't require a long-term commitment as the securities are bought and sold simultaneously. However, it would be well-suited to stay invested for at least 3 months to balance out exit load charges.
3. Thrives in a volatile market - As mentioned above, the best arbitrage funds are ones that thrive during market volatility helping investors with a steady income source.
4. Balanced funds - Yet another advantage of arbitrage funds is that it is well-balanced and is a hybrid of debt and equity mutual funds. This allows the fund to have the benefits of both.

• The expense ratio of the Kotak Equity Arbitrage Fund is 0.43%, its PE ratio is 30.22, and its Sharpe ratio is 1.54. It has an exit load of 0.25%, a minimum lump sum of Rs. 5,000, and its benchmark is Nifty 50 arbitrage.
• The fund is diversified in the following sectors: private banks (12.57%), miscellaneous (10.10%), home financing (4.85%), oil & gas-Refining & marketing (4.56%), and others (19.81%). The rest of the 48.11% is diversified into 47 other sectors.

• The ICICI Pru Equity-Arbitrage Fund expense ratio of the fund is 0.39%. With a PE ratio of 33.76 and a Sharpe ratio of 1.34, the fund has an exit load of 0.25%. The fund has a minimum lump sum of Rs. 5,000, with its benchmark being Nifty 50 Arbitrage.
• The diversification of the fund is as follows: Private banks (11.11%), G-sec (11.10%), IT services and Consulting (4.94%), miscellaneous (13.14%), and others (4.80%). The remaining 54.81% of the fund is diversified into 44 different sectors.

• The exit load of the fund is 0.25%, with a minimum lump sum of Rs. 5,000, and its benchmark is Nifty 50 Arbitrage. The expense ratio of the Nippon India Arbitrage Fund is 0.21%, the PE ratio is 29.05, and the Sharpe ratio is 1.39.
• The fund is diversified as follows: private banks (14.90%), miscellaneous (8.59%), IT services and consulting (5.84%), home financing (5.23%), and others (12.73%). The rest of the 52.71% of the fund is split into 45 other sectors.

• The expense ratio of the fund is 0.36%, the PE ratio is 29.15, and its Sharpe ratio is 1.50. The exit load of the fund is set at 0.25%, with a minimum lump sum of Rs. 5,000.
• Here’s how the fund is diversified: private banks (17.25%), miscellaneous (9.52%), Oil & Gas - Refining and Marketing (7.02%), Others (6.87%), and G-sec (6.85%). The remainder of the 52.49% of the share is diversified in 49 other sectors.

• The Tata arbitrage fund has an expense ratio of 0.28%, a PE ratio of 31.55, and a share ratio of 1.43. The exit load is set at 0.25%, and its minimum lump sum is Rs. 5000. The benchmark for the fund is Nifty 50 arbitrage.
• Here’s how the fund is diversified: Private banks (11.154%), miscellaneous (6.04%), specialised finance (5.39%), Oil & gas - Refining & Marketing and Others 21.33%. The rest of the 50.68% of the fund is diversified in 42 other sectors.

Arbitrage mutual funds are mutual fund schemes that essentially leverage the differences in prices in markets in order to generate profits. The primary aim of arbitrage funds is to deliver arbitrage profits via price differences that occur in different capital markets. Arbitrage, in simple terms, means purchasing and selling securities in different markets to gain risk-free returns or profits. If the price of any security is different in different markets, mutual fund investors can make risk-free gains by buying securities in the market where the price is lower and selling the same securities in the market where the price is higher.

You could say that arbitrage funds work with a predominant investment in equities but aim to minimise risk through the strategy of arbitrage. Funds work by taking advantage of price differences between stock exchanges or market segments. As per SEBI, the Securities and Exchange Board of India, arbitrage funds have to invest a minimum of 65% of their capital in equity and related securities.